Bond Vigilantes - Claudia Calichhttps://www.bondvigilantes.com
M&GThu, 12 Sep 2019 16:01:50 +0000en-GBhourly1Is China really a currency manipulator?https://www.bondvigilantes.com/blog/2019/08/07/is-china-really-a-currency-manipulator/
https://www.bondvigilantes.com/blog/2019/08/07/is-china-really-a-currency-manipulator/#respondWed, 07 Aug 2019 08:46:30 +0000https://www.bondvigilantes.com/?p=18038Last night, the US Treasury designated China as a currency manipulator. This has occurred a few times in the past, most recently in 1994. Though China has been on the Treasury’s watch list for some time (alongside several other countries), given that the most recent Treasury report published in May did not name China a manipulator, it begs the question, what has changed between then and now?

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]]>Last night, the US Treasury designated China as a currency manipulator. This has occurred a few times in the past, most recently in 1994. Though China has been on the Treasury’s watch list for some time (alongside several other countries), given that the most recent Treasury report published in May did not name China a manipulator, it begs the question, what has changed between then and now?

The criteria is based on the chart below. One of the issues with the criteria is that it focuses on the largest bilateral trade deficits in nominal terms. Arguably, this reduces the need to monitor bilateral imbalances for economies that are much smaller in size, where the surplus may be large (as a percentage of the economy) but small in nominal terms. One example is Israel, a small economy that posted a larger surplus, as a percentage of its GDP, than several other countries on the monitoring list (see our prior blog) This also means that a small open economy like Thailand would fall just below the $20 billion arbitrary threshold, but India, a larger closed economy would just exceed the threshold.

According to the Treasury’s most recent estimates below (China does not publish that data), China has not materially intervened in the currency for a large part of the last year. If anything, it was selling USD reserves to prevent a faster depreciation in 2015-2016, when it further tightened capital controls. Based on PBoC data, we do not believe it has materially intervened to weaken its currency since then. The Renminbi has however now crossed the 7 rubicon.

The US Treasury believes that China’s reserves are ‘above standard measures of reserve adequacy’. That may be true for a country that has capital controls, but as China aims to gradually open up its capital account, the level does not seem to be excessive. Reserves have been relatively stable since 2017 at $3.1 trillion, so the IMF’s calculations below are still valid.

From the criteria described above, it appears that nothing is likely to have changed since May, except that the trade war between both countries has intensified. China has been running large bilateral trade surpluses with the US for some time and the US allegations of protectionism and state subsidies are warranted, but nothing new.

Following the recent US announcement that they will impose 10% tariffs on an additional $300 billion of Chinese goods, the PBoC allowed the Renminbi to depreciate past the closely-watched 7 level, but the depreciation was roughly in line with other Asian currencies. If anything, the Renminbi had, until recently, depreciated less than neighbouring currencies, which is something that the PBoC monitors closely when setting its daily fixing.

The bottom line? The data alone does not justify why China was designated a manipulator now, as opposed to May or October, when the next Treasury report is set to be published. The trade war continues to escalate and the timing is much more related to that, than what the data indicates. This is not over. Stay tuned.

]]>https://www.bondvigilantes.com/blog/2019/08/07/is-china-really-a-currency-manipulator/feed/0Emerging Markets: 5 key issues to watch in 2019https://www.bondvigilantes.com/blog/2019/01/14/emerging-markets-5-key-issues-watch-2019/
https://www.bondvigilantes.com/blog/2019/01/14/emerging-markets-5-key-issues-watch-2019/#commentsMon, 14 Jan 2019 12:30:50 +0000https://www.bondvigilantes.com/?p=17635Emerging Markets (EM) debt had a torrid 2018 as global macro risks (including general geopolitics and trade wars), softer EM growth and idiosyncratic stories (Argentina, Turkey), all repriced relatively expensive valuations at the beginning of the year. Are the new prices a better reflection of fundamentals? This will largely depend on the evolution of 5 key topics.

China-US – upside surprise…

]]>Emerging Markets (EM) debt had a torrid 2018 as global macro risks (including general geopolitics and trade wars), softer EM growth and idiosyncratic stories (Argentina, Turkey), all repriced relatively expensive valuations at the beginning of the year. Are the new prices a better reflection of fundamentals? This will largely depend on the evolution of 5 key topics.

China-US – upside surprise? The ongoing trade conflict has been a significant driver of global asset prices as the tension has hit global trade as well as corporate earnings (including Apple). If the present trade talks go nowhere, one should expect further global growth weakness, something which could affect EMs, as we highlighted last summer in “How vulnerable are Emerging Markets to trade wars?”For China, the conflict comes at a difficult time for the economy, as the cost-benefit of additional policy stimulus is lower than it was a decade ago, given the higher leverage in the system – inflation is good to cut debt, but comes at a very high competitiveness cost. Despite the negative headlines, investors should not rule out any potential positive tailwind: the US-China relationship could stabilise this year, having a positive impact on asset prices, including EM debt.

The US Federal Reserve (Fed) – more dovish, but higher issuance? Markets were quick to price in additional Fed hikes this year, but plunging oil prices, a dovish Fed and lukewarm data has made them now forecast the end of the tightening cycle. However, and in the absence of a significant US slowdown, treasuries appear to be pricing in little risk premia, especially since supply remains healthy – usually a negative for bond prices. US government debt is expected to remain high, given current projections of a US fiscal deficit and also because some natural buyers, including some central banks, have recently diminished their Treasury holdings. China, for instance, is not running big Current Account surpluses any more, hence it has less ability to park those extra dollars elsewhere.

Elections and idiosyncratic risks – volatility and opportunity: There is a stream of EM general elections scheduled for 2019 which may bring a degree of volatility, and opportunity. In terms of potential market reactions, Argentina’s poll, in October, may be the most binary: pro-market incumbent Macri is likely to seek re-election (bullish outcome), but he might face former President Christina Kirchner (expect a negative market reaction if she wins), while the Peronist Party will also be contending (expect a neutral reaction if they decide to continue the IMF-led adjustment path and a negative reaction if they do not). Other elections in Ukraine (March), Indonesia (April), India (April/May) and South Africa (May), may also bring volatility. In other countries, key elections are now behind, so the focus has shifted towards the implementation (or not) of the promises made – for instance, we are monitoring the progress of Brazil’s much-expected pension reform, while expecting further clarity on Mexico’s economic policies. Elections of course are crucial as government action can either lead to or reduce potential idiosyncratic risks. As ever in EMs, avoiding those – usually the largest underperformers – is paramount. Last year, for example, the worst performers were not linked by any common theme, but suffered from specific, idiosyncratic issues, such as large financing needs (Argentina), plunging oil prices (Nigeria, Ecuador and Venezuela), or an unconvincing fiscal adjustment (Zambia and Costa Rica).

Commodities – symptom or cause? Despite the common perception of a strong link between oil and EMs, developing nations’ sensitivity to oil prices is rather uneven. Should oil go up, Turkey, India and other importers will see a deterioration in their Current Accounts, while Middle East and other EM oil exporters (e.g. Russia, Nigeria) will benefit. Therefore, oil price volatility is likely to generate diverse asset returns. On the other hand, a significant decline in metal-based commodities tends to have a negative impact on most EMs not only because it hits exporters, but also because it often signals weak demand from importers (like top-consuming China), suggesting slower global growth. For instance, the slowdown in China’s property market has negatively affected steel and iron ore prices globally.

Corporate fundamentals – the bright spot again? Low corporate default rates and credit improvements of corporate issuers were the bright spot of EMs last year (for more, don’t miss Charles de Quinsonas’ “Emerging Markets High Yield: is there value after the sell-off?”) Stronger earnings and disciplined capital expenditures resulted in a net debt reduction throughout the year: as of the end of June (latest data available), EM corporates’ net leverage was below 2.75x, down from 3.5x times at the peak in 2016. Looking into 2019, we believe corporate fundamentals will start stabilising, at the same time that EM High Yield default rates may pick up slightly to 2 to 3% (from less than 2% in 2018), on the back of tougher macro fundamentals in a few countries, such as Turkey, China and Argentina. Default rates are nevertheless likely to remain below their long-term average.

So, whilst global macro risks are unlikely to recede in 2019, the yield on offer by EM debt (around 7% in sovereign US dollar bonds) is at its highest level since the 2007-2008 Global Financial Crisis, raising prospects for improved returns relative to last year. In fact, since 1994, hard currency bonds have never posted two consecutive years of negative returns.

Local debt is a different matter, as currency adjustments often last for a few years depending on the economic cycle, monetary policy and the outlook of the balance of payments. However, and looking at valuations, the Current Account adjustment that has taken place in many countries and the rise in real yields, we believe that the bulk of the local currency correction is behind us. But, since hard currency debt has also cheapened, we remain neutral in terms of allocation between hard and local currency – 2019 will bring opportunities in both.

]]>https://www.bondvigilantes.com/blog/2019/01/14/emerging-markets-5-key-issues-watch-2019/feed/1Brazil’s election: What’s at stake?https://www.bondvigilantes.com/blog/2018/09/18/brazils-election-whats-stake/
https://www.bondvigilantes.com/blog/2018/09/18/brazils-election-whats-stake/#respondTue, 18 Sep 2018 15:20:18 +0000https://www.bondvigilantes.com/?p=17203Global investors are paying special attention to the forthcoming general election in Brazil, not only because the country is the world’s eighth-largest economy, ahead of Italy and Canada, but also because in these turbulent times for Emerging Markets (EMs), an unexpected or market-unfriendly outcome could bring more volatility to the entire asset class. After the recent sell-offs in Turkey and …]]>Global investors are paying special attention to the forthcoming general election in Brazil, not only because the country is the world’s eighth-largest economy, ahead of Italy and Canada, but also because in these turbulent times for Emerging Markets (EMs), an unexpected or market-unfriendly outcome could bring more volatility to the entire asset class. After the recent sell-offs in Turkey and Argentina, the EM space is delicate and could be especially sensitive to what happens in Latin America’s No. 1 economy. So, what’s happening?

The election recently took a sharp turn after the stabbing of presidential candidate Bolsonaro, who is now recovering and will continue to run. The dramatic event, though, led to a rally of Brazilian assets as investors started to price in that the far-right leader may now have more chances to win. The positive reaction came not so much because investors favour his views, but because he may now get some sympathy votes, reducing the popularity of extreme left leaders – generally more disliked by markets. As seen on the chart, the real strengthened and the cost to protect sovereign debt against default (CDS) cheapened following the Bolsonaro attack, and also after a court ruled that former left-wing president Lula, now in jail, could not run.

Bolsonaro was already Brazil’s front-runner before the attack, but his share in the polls rose to 26%, from 22%, afterwards, according to the latest polls, from Sept. 10. As seen on the chart below, he is followed by Ciro Gomes, a populist who has questioned central bank independence, and market-friendly candidate Geraldo Alckmin, who is levelled with Marina, a centre-left leader.

However, ranks could change with Lula out of the race. Some of his votes may go to the Workers Party (PT) candidate Fernando Haddad, or to Marina, or even become blank, in protest. This distribution could even things out, increasing the chances of a centrist victory – and the possibility that Alckmin makes it through the first round on Oct. 7. Some now predict that Alckmin may face Bolsonaro in the second and final round on Oct. 28.

Financial markets may welcome either of those candidates, especially Alckmin, although in my view, investors may not be totally pricing in the former São Paulo governor’s chances to implement the reforms he is proposing: with an unruly and highly fragmented Congress, Alckmin’s prudent fiscal and social security approach may be difficult to achieve.

Investors also seem more open to a Bolsonaro presidency than they seemed in the past: This has become more prevalent as some of his advisors have reiterated plans to privatise state assets, including crown jewel Petroleo Brasileiro SA (Petrobras) or lender Banco do Brazil. Asset sales, Bolsonaro’s team argues, should cut the country’s soaring debt (the government’s total gross debt to GDP reached 74% last year, up from 51% in 2011). However, markets may also be a bit ahead of themselves when assessing Bolsonaro, as he has not been as keen on privatisations in the past: the former army captain has publicly praised the nationalist, state-driven policies of the country’s military government in the 1970s.

But if the Bolsonaro vs Alckmin prediction is wrong and politically-fatigued Brazilians choose a non-centrist, left-wing candidate such as Gomes, then we could expect a large repricing of CDS and further real weakness. In such case, we could expect Banco Central do Brazil to use its large firepower to smooth a potential depreciation. Apart from buying reals to support the currency, we could see the central bank increase Foreign Exchange swap auctions, if needed.

Finally, and in terms of rates, we have seen local government bond yields rising to price over 300 basis points in rate hikes for the next 12 months – perhaps this is a parallel bearish move upwards reflecting recent CDS moves, as seen in the chart below.

]]>https://www.bondvigilantes.com/blog/2018/09/18/brazils-election-whats-stake/feed/0Can Russia stomach new US sanctions?https://www.bondvigilantes.com/blog/2018/08/15/can-russia-stomach-new-us-sanctions/
https://www.bondvigilantes.com/blog/2018/08/15/can-russia-stomach-new-us-sanctions/#respondWed, 15 Aug 2018 13:35:04 +0000https://www.bondvigilantes.com/?p=17040After the summer break, the US Congress is scheduled to review various bills proposing additional sanctions on Russia. The proposals includeadditional restrictions on Russian imports and exports to the US, as well as on activities of Russian banks in the country. Under consideration there will also be a ban, for US citizens, to trade any newly-issued Russian sovereign debt with a maturity of m…]]>After the summer break, the US Congress is scheduled to review various bills proposing additional sanctions on Russia. The proposals includeadditional restrictions on Russian imports and exports to the US, as well as on activities of Russian banks in the country. Under consideration there will also be a ban, for US citizens, to trade any newly-issued Russian sovereign debt with a maturity of more than 14 days. Trading of older debt remains unaffected. Since US sanctions on Russia started in 2014, financial institutions and corporates have been able to muddle through some of the restrictions – will it be different this time?

If the US approves the ban that would prevent US investors from financing the Russian government, it is likely that many European banks and investors would follow suit, especially if they have operations in the US. This could dramatically reduce daily trading volumes of the new debt.

How damaging could this be for Russia’s financing needs? As seen on the two charts below, Russian sovereign debt amortizations are largely concentrated on ruble-denominated local bonds, known as ‘OFZs’. The Central Bank estimates that approximately 28% of them are currently held by non-residents, as seen on Chart II.

It is possible, however, that the non-resident ownership figure is underestimated if some of the exposure is held through synthetic instruments, such as credit-linked notes, total return swaps, etc. An IMF analysisof the evolution and opening up of Russia’s domestic market highlighted last year the significant role of foreign investors, especially in the earlier years, such as 2012. But while the risk of underestimating foreign ownership exists, investments in Russian local debt through proxies may be less than in the past, when foreign investors could not easily access the local market and had to use alternative instruments to gain exposure to Russian local debt.

If we assume that US and European investors (including their proxy holdings) own 33% of the OFZ market and, conservatively, 100% of the foreign currency debt, this could imply that Russia could face a funding gap of around $5-7 billion per year between 2019-23. However, and based on past investor surveys, non-residents are most likely invested in securities maturing in 5-15 years, while local investors, including the banks, tend to favour shorter-dated securities. This would give some breathing room for Russia to adapt to the new sanctions, if approved.

Furthermore, the recent recovery in oil prices and a pick-up in economic activity has allowed Russia to return to a fiscal surplus, in addition to its long-standing current account surplus. As seen on Chart III, Russia’s foreign exchange reserves, through USD purchases by the Central Bank, have recovered to $450 billion, just below their pre-2014 sanctions level. If oil prices were to remain at current levels and if the potential new round of sanctions does not materially dent economic growth through a shock in confidence and domestic liquidity, the proposed sanctions, while a set-back, seem ultimately surmountable for Russia’s strong balance sheet.

Chart III: High oil prices and strong reserves could help Russia stomach more sanctions

]]>https://www.bondvigilantes.com/blog/2018/08/15/can-russia-stomach-new-us-sanctions/feed/0How vulnerable are Emerging Markets to Trade Wars?https://www.bondvigilantes.com/blog/2018/08/14/vulnerable-emerging-markets-trade-wars/
https://www.bondvigilantes.com/blog/2018/08/14/vulnerable-emerging-markets-trade-wars/#respondTue, 14 Aug 2018 09:01:39 +0000https://www.bondvigilantes.com/?p=17028Emerging Markets Portfolio Manager Claudia Calich analyses the potential effects of an escalation of the US-China trade tensions on Emerging Markets. Despite the diplomatic rows and all the column inches written, Claudia discusses how popular products such as French wine and cheese will always find their way to the end consumer, no matter how many barriers along the way. Calich also explains wh…]]>Emerging Markets Portfolio Manager Claudia Calich analyses the potential effects of an escalation of the US-China trade tensions on Emerging Markets. Despite the diplomatic rows and all the column inches written, Claudia discusses how popular products such as French wine and cheese will always find their way to the end consumer, no matter how many barriers along the way. Calich also explains which countries may win or lose in the present environment and which EM government and corporate sectors look more attractive.

Q&A with EM Portfolio Manager Claudia Calich

There are various channels that can be impacted by trade wars: imported goods may become more expensive; currencies of exporting countries may depreciate and investment decisions could be postponed until there is more clarity. Trade wars may also reduce consumption if the higher prices are not absorbed by firms. And we could also see a tightening of financial conditions if Foreign Direct Investment is reduced or if the risk premia on bonds or equities increases. All these factors could reduce economic activity.

But at this point, it is difficult to quantify the precise impact of the ongoing tensions because production plants and global supply chains cannot change or shift countries overnight. A new tariff may be imposed, but paying it might be cheaper than moving an entire production process around the world. It is yet to be seen whether US companies will be able to pass on the extra costs to their consumers, or whether those consumers will be willing to accept higher prices. There could be ways around the tariffs: we recently saw that when Russia put barriers on certain Western products, French wine and cheese found their way through different countries to reach the end destination. We may also see third-party effects: for example, trade barriers on Chinese goods may help Mexican exports to the US. Some US car makers, such as Ford, already have substantial operations in Mexico.

Commodities have recently edged down on concerns that the trade tensions could weaken Chinese growth, and therefore reduce demand for metals – do you expect further declines?

We could see more weakness if there was a big decline in Chinese growth. But let’s not forget that China’s current account surplus barely accounts for 1% of GDP now, far less than 10% ten years ago, as the country shifts its economy towards a consumption-led model rather than a manufacturing and export one. The commodities that China imports tend to be used in infrastructure projects – more dependent on domestic growth – whereas the tariffs are mostly on manufacturing products. Therefore, demand for commodities may not fall as much as some people expect – unless China’s growth suffers a major slowdown because of the trade wars and/or we see a policy response from the Chinese authorities that creates financial instability.

What is your view on those countries that export significantly to China?

This needs to be looked at on a country by country basis. Copper-producing Chile, for instance, has very little debt, a floating exchange currency and no major current account deficit concerns. If copper prices collapse, the central bank would have to hike interest rates and may be forced into running fiscal deficits in the medium term – but they would have the tools to defend themselves.

Other countries, however, may be much more vulnerable. Zambia, for instance, has a large twin deficit, giving it less flexibility in an extreme scenario.

Countries with larger US dollar-denominated debt would also suffer if an escalation of trade tensions led to a stronger US dollar.

What is the worst that could happen?

China’s response will be crucial. If they, for example, started using the currency as a negotiation tool – forcing a devaluation – this would add more tension and perhaps lead to financial instability. One can never rule out the fat-tail probabilities of an extreme scenario happening, which would most likely lead to a risk-off environment, with rising spreads and bigger deficits, but this is not my base case scenario.

However, China has reiterated its commitment to financial stability and to not using its currency as a tool. Like in China, other EM central banks have improved their governance and credibility over the past few years, so as long as their response is adequate and well communicated, their credibility – and stability – may not be hugely impacted.

We have seen several rate hikes in EMs so far this year – is this a reaction against a rising US dollar? Do you expect more rate increases in EMs?

They all have their own catalysts: Turkey and Argentina raised rates to defend their currencies because they had to, given their large current account deficits and financing needs. In Eastern Europe we have seen higher rates because countries such as the Czech Republic, Romania and Hungary are showing signs of overheating, which will cause inflation to rise.

But given the recent softer data in Europe and parts of Asia, and mixed US data, most EM implied future rates are pointing towards an increase.

Are higher EM interest rates already priced in?

What is your main worry in the EM space?

Some countries, especially weaker credits such as Sub-Saharan Africa sovereigns, Argentina or Bahrain are dependent on high growth or low refinancing yields to keep their debt levels stable. While we have seen a broad-based reduction on current account deficits in many EM economies and we can say that that part of the rebalancing process is complete, we have only started to see improvements on their fiscal deficits. Higher growth will help, but in some cases, there is still much more to be done.

Where could investors find opportunity in EMs at present?

Following the sell-off in Chinese credit, spreads have reached levels that may be attractive, especially in the real estate sector. We also favour local market exposure in countries where real or nominal rates look attractive, such as Brazil and Uruguay, or where it is likely that inflation has peaked, such as Mexico. In the corporate space, we favour quasi-sovereign oil and gas issuers with sound fundamentals and certain consumer businesses in Peru and real estate firms in Mexico. In terms of local or hard currency debt, we had a positive view on locally-denominated debt after 2015 as we viewed the US dollar rally was basically done. US-dollar denominated debt is more attractively priced now than it was earlier this year as spreads have widened and we are starting to find pockets of value in this space. As ever in EMs, it’s a cherry-pickers’ market.

]]>https://www.bondvigilantes.com/blog/2018/08/14/vulnerable-emerging-markets-trade-wars/feed/0EM bonds YTD review and outlookhttps://www.bondvigilantes.com/blog/2018/07/11/em-bonds-ytd-review-outlook/
https://www.bondvigilantes.com/blog/2018/07/11/em-bonds-ytd-review-outlook/#respondWed, 11 Jul 2018 13:01:49 +0000https://www.bondvigilantes.com/?p=16873While emerging market bonds have notably underperformed in the year-to-date period, Fund Manager Claudia Calich believes the longer-term fundamental case for the asset class remains intact. The outlook for broad-based global economic growth is still in place, for example, which should help fiscal improvements and deleveraging in emerging countries. In this Bond Vigilantes video, Claudia also no…]]>While emerging market bonds have notably underperformed in the year-to-date period, Fund Manager Claudia Calich believes the longer-term fundamental case for the asset class remains intact. The outlook for broad-based global economic growth is still in place, for example, which should help fiscal improvements and deleveraging in emerging countries. In this Bond Vigilantes video, Claudia also notes why she thinks the market’s recent decline has left areas of the emerging debt markets looking fairer value, with attractive relative yields supporting her assessment. At the same time, the performance of local currencies (are they weak or is the US dollar strong?), international trade tensions, and idiosyncratic stories in Turkey and Argentina must be monitored closely.

]]>https://www.bondvigilantes.com/blog/2018/07/11/em-bonds-ytd-review-outlook/feed/0Bahrain: avoiding the first sovereign sukuk default?https://www.bondvigilantes.com/blog/2018/06/26/bahrain-avoiding-first-sovereign-sukuk-default/
https://www.bondvigilantes.com/blog/2018/06/26/bahrain-avoiding-first-sovereign-sukuk-default/#respondTue, 26 Jun 2018 09:25:57 +0000https://www.bondvigilantes.com/?p=16822Bahrain spreads have widened in recent months, despite the rise in oil prices. The market is focusing on the $750 million Bahrain Sukuk maturing on November 22, 2018. Given that the country’s international reserves are estimated at around $2.1 billion, the country will need additional funding to repay it. The market consensus is that Bahrain will receive financial support from neighbouring Sau…]]>Bahrain spreads have widened in recent months, despite the rise in oil prices. The market is focusing on the $750 million Bahrain Sukuk maturing on November 22, 2018. Given that the country’s international reserves are estimated at around $2.1 billion, the country will need additional funding to repay it. The market consensus is that Bahrain will receive financial support from neighbouring Saudi Arabia and potentially other Gulf Cooperation Countries, who will seek to avoid the economic, financial contagion and pressures on their own economies and currency pegs should a default (and de-peg) ensue. The fact that the Bahrain is a relatively small economy versus its neighbours is another reason why the markets believe that it is a relatively small price to pay in exchange for diffusing the problem into the future. It is not clear, however, what kind of conditions its neighbours would demand in exchange for support. Would they require fiscal tightening, so that Bahrain’s debt dynamics can start stabilizing in a few years? But what if the market consensus is wrong, the support does not materialize and Bahrain cannot pay its sukuk?

Why are markets starting to worry about a Bahrain default? Debt has doubled in just 3 years, to over 90% of GDP, as the decline in oil prices negatively impacted the fiscal position of the oil exporters in the Middle East. Unlike, most of its neighbours, however, the fiscal adjustment required (i.e. reducing some expenditures such as subsidies and benefits or broadening or increasing non-oil taxes, including VAT) has been very slow.

Given a large debt stock and a sizeable fiscal deficit (flow), it appears that Bahrain’s debt dynamics will continue to deteriorate, especially if borrowing costs, which have been relatively low thus far reflecting debt that had been issued at lower interest rates a few years ago, increase further. Increasing US rates continue to be transmitted very quickly into Bahrain’s financial sector due to its currency peg and this is not helping either. Even with Brent in the mid-70s, Bahrain’s spreads remain elevated, signalling that for risk premia to decline, either much higher levels of oil prices, an explicit statement by neighbouring countries detailing financial support or an announcement of a large fiscal adjustment by the government is required.

The fact that the security maturing in November is a sukuk adds more uncertainty due to there having been some corporate sukuk defaults in recent years (with the exception ofDana Gas ($700 million, Al Mudarabah) and Golden Belt ($650 million, Al Ijara)) which have been relatively small and limited to a handful of bonds. A Bahrain default, if it were to happen, would be the first sovereign sukuk default, comprising of 4 sukuks and 9 conventional bonds, totalling almost $15 billion. Sovereign conventional bond defaults for larger issuers with numerous bonds and a wide investor base can be complex and its resolution time consuming. The Argentina 2001 default and subsequent legal battle with holdouts took over a decade to resolve. Venezuela and PDVSA bonds were issued under different legal structures, are held by a wide array of investors and will likely take many years to be restructured. Bahrain, incidentally, is not part of the JPM emerging market bond indices as the country is classified as high-income (like Saudi Arabia, Qatar and Kuwait). Oman, however, is part of the indices as it is not considered a high-income country.

Sukuk defaults have additional legal layers of uncertainty versus a conventional bond (for discussions on Sukuk defaults and legal considerations, see here and here). The trust agreement is normally governed by English law, while the underlying lease agreements (the asset-based part of the sukuk) are governed by national law, Bahraini law in the case of its own sukuks. Finally, whether or not the structure is Sharia compliant, is subject to a third interpretation. The rating agencies do not seem to explicitly take into account the legal risks when rating the transactions. One of them, has stated that ‘XXX does not express an opinion on whether the relevant transaction documents are enforceable under any applicable law. However, XXX’s rating on the certificates reflects its belief that XXX would stand behind its obligations. When assigning ratings to the sukuk issuance, XXX does not express an opinion on its compliance with sharia principles.’

The oddity is that, despite being far more complex from a legal standpoint, spreads on Bahrain sukuks are currently far lower than the spread on its conventional bonds. That is largely because of the strong local support and demands for sukuks vs conventional bonds in recent weeks. Some local investors also cannot sell an instrument below par, as this will require them to account for its market to market loss and may also not be permitted according to Islamic finance. Many international investors have also invested in sukuks, but have the ability to arbitrage between sukuks and conventional bonds as they do not have the same market-to-market considerations or a preference for sharia vs non-sharia compliant instruments.

Given the potential legal complexities should a default occur, not to mention the underlying sovereign credit risk, investors are not being compensated for the risks on Bahrain’s sukuks.

]]>https://www.bondvigilantes.com/blog/2018/06/26/bahrain-avoiding-first-sovereign-sukuk-default/feed/0An update on Argentinahttps://www.bondvigilantes.com/blog/2018/05/08/an-update-on-argentina/
https://www.bondvigilantes.com/blog/2018/05/08/an-update-on-argentina/#respondTue, 08 May 2018 16:00:46 +0000https://www.bondvigilantes.com/?p=16682Argentinian assets have been under material pressure in recent days. I thought it would be useful to write my thoughts on the recent moves and implications for markets going forward.

Over the past two months, the Argentinian peso had become overvalued in real terms following large inflows from foreign investors in 2017. These capital flows caused the nominal exchange rate to depreciate by much…

]]>Argentinian assets have been under material pressure in recent days. I thought it would be useful to write my thoughts on the recent moves and implications for markets going forward.

Over the past two months, the Argentinian peso had become overvalued in real terms following large inflows from foreign investors in 2017. These capital flows caused the nominal exchange rate to depreciate by much less than inflation. Those investing in Argentinian assets cited the carry trade theme, relatively low volatility, and the entering of Argentinian local currency sovereign bonds into the JP Morgan Government Bond Indices as investment rationales. However, the tide started to turn late last year when the Central Bank of Argentina (BCRA) made a policy mistake by raising the 2018 inflation target from 10 to 15%. The adjustment of the inflation target subsequently allowed the BCRA to cut interest rates in early January this year.

The cut in interest rates dented the BCRA’s credibility, and concerns grew about whether monetary policy was free of interference from the government. Another policy mistake was the announcement of a 5% tax on Argentinian peso Treasury bill investments, which impacted both locals and foreigners and led to a reduction in holdings of Argentinian peso Treasury bills by investors. Higher than expected inflation readings, and a strengthening of the US dollar finally generated large pressures on the Argentinian peso. After attempting to support the local currency by buying over USD 5 billion worth of pesos in the currency market, the BCRA finally realised that its monetary stance had to be tightened. We have now witnessed three emergency hikes (a combined 12%), bringing the policy rate to an eye-watering 40%. I believe the monetary authorities will now be successful in slowing the depreciation of the currency going forward.

The overvalued peso also contributed to Argentina’s current account deficit widening 5%. I expect the current account deficit to begin to start narrowing again as the currency moves into equilibrium (say, to 24-26 against the US dollar by year-end) and the economy slows as a result of the monetary and fiscal tightening (a 0.5% tightening of the fiscal deficit was also announced). The implications of this will be higher inflation this year and possibly next, lower growth and a further decline in Macri’s popularity.

If this a default situation? Not yet. I see this as a re-pricing of Argentinean risk which had started earlier in the year, coupled with an already ongoing emerging market sell-off in the local and hard currency space.

On the positive side, I believe that there are two silver linings for the time being.

Firstly, the next election is not until late 2019, so there is some time for the authorities to take its bitter medicine this year – including more utility tariff hikes, a depreciation of the peso, and attempt to control the next public wage negotiations in September. Accepting these tough measures will allow the economy to readjust over the course of 2018. The opposition and Peronists are still divided, so while Macri’s re-election chances and policy continuity look much more complicated now, it is still not a given that Argentineans will choose another populist government.

Secondly, the IMF may be prompted to get involved. Unlike other countries which would ideologically be opposed to an IMF program (Venezuela for sure, potentially Turkey, while Ecuador is uncertain as always), the authorities may end up under a program if they lose access to the markets and/or Argentina experiences a balance of payment crisis fuelled by capital flight. Argentina and the IMF have had a tumultuous relationship in the past, but under different administrations (Menem, Nestor and Cristina). The goal in this case, for both sides, would be to ensure stability so that Argentina does not return to its failed populist policies under a new administration. The current government is full of technocrats that understand this and, if push comes to shove, would convince Macri that this is his least worst option. Such an event would provide sufficient funding sources until at least the end of next year.

]]>https://www.bondvigilantes.com/blog/2018/05/08/an-update-on-argentina/feed/0The Venezuelan cash crunch: exporting passports as a palliative?https://www.bondvigilantes.com/blog/2018/01/23/the-venezuelan-cash-crunch-exporting-passports-as-a-palliative/
https://www.bondvigilantes.com/blog/2018/01/23/the-venezuelan-cash-crunch-exporting-passports-as-a-palliative/#respondTue, 23 Jan 2018 10:04:25 +0000https://www.bondvigilantes.com/?p=16395Venezuela’s cash flow crisis has been well covered. The recent default on its sovereign debt and likely default on the debt issued by its state-owned company, Petroleos de Venezuela SA (PDVSA), combined with collapsing imports attest to its ongoing cash crunch and humanitarian crisis. ¹

A change of economic policy however, would alleviate the crisis and improve the patient’s health. This could …

]]>Venezuela’s cash flow crisis has been well covered. The recent default on its sovereign debt and likely default on the debt issued by its state-owned company, Petroleos de Venezuela SA (PDVSA), combined with collapsing imports attest to its ongoing cash crunch and humanitarian crisis. ¹

A change of economic policy however, would alleviate the crisis and improve the patient’s health. This could include measures such as:

A better environment for the private sector

Unification of the currency regime

Securing foreign financing to resume capital expenditure in the oil sector where production has been falling at a rate of 10% per year

Asset sales to reengage the private sector and increase non-oil production

End of monetary financing of the budget deficits and hyperinflation

Removal of oil price subsidies and price controls on essential goods

Resuming the dissemination of government statistics

Resuming a dialogue with the IMF and other multilateral organisations

Debt restructuring in combination with the above

Free and fair elections

In practice, none of the above measures are likely to be adopted under the status quo. Instead, new creative ideas continue to be announced by the government, including the upcoming issuance of a new cryptocurrency, the ‘petro’, to be backed by oil in an attempt to alleviate its current cash crunch.

An alternative creative idea that I have come up with, is the establishment of a citizenship by investment program (CBI), similar to the existing ones below.

The requirements for each country vary, sometimes including residency conditions, but always requiring an investment into a government run fund, real estate and/or bonds. Some countries provide temporary residency, with an eventual citizenship possible though not automatic (i.e. certain EU countries with the exception of Malta and Cyprus). The revenues from such programs can be material. Dominica’s, for example, exceeds 5% of GDP, while St Kitts has fallen to around 4% (revenues were over 12% of GDP at inception).

A Venezuelan passport is attractive as it entitles the holder to visa-free travel to over 130 countries, including the European Union and it ranks a not-too-shabby 34th place globally, ranking higher than Peru, Colombia and Panama. See other rankings for passports here. I assume that a Venezuelan program would not require residency in the country but would require a monetary contribution for the equivalent of $75,000. This level is slightly lower than that of its neighbouring Caribbean countries due to perceived higher risk (e.g. additional US sanctions or controversy, risk of changes on visa requirements (i.e. EU’s Schengen area) if the vetting process is perceived to be too lax, past controversies in alleged sales of passports to terrorists, etc). I also estimate the external financing gap for Venezuela in 2018 at around $4.9 billion. This assumes an oil price of $50 for the PDVSA mix and total production of 2 million of barrels per day. Given that a large portion of the production is already pre-committed to China, Russia and Cuba and assuming domestic oil consumption of around 500-600,000 barrels per day, the actual amount of oil that is exported at market prices is roughly only a third of total production. It also assumes that no further payments will be made on its bonded external debt (Venezuela and PDVSA).

Assuming that each Venezuelan passport raises $75,000, if Venezuela grants 65,000 citizenship applications, it could close its financing gap for this year. Putting the amount into context vis-a-vis the country’s population, that is higher than the estimated amount of passports sold by Saint Lucia or Malta, but not scandalously so. Is this idea feasible? Probably not, but given the desperate cash crunch in Venezuela, one must think outside the box.

[1] Technically, the bonds issued by PDVSA are still trading with accrued interest. The bonds issued by the sovereign, are trading without accrued interest, which is how defaulted instruments normally trade.

]]>https://www.bondvigilantes.com/blog/2018/01/23/the-venezuelan-cash-crunch-exporting-passports-as-a-palliative/feed/0Emerging markets debt: 2017 post-mortem and 2018 outlookhttps://www.bondvigilantes.com/blog/2018/01/03/emerging-markets-debt-2017-post-mortem-2018-outlook/
https://www.bondvigilantes.com/blog/2018/01/03/emerging-markets-debt-2017-post-mortem-2018-outlook/#respondWed, 03 Jan 2018 15:02:04 +0000https://www.bondvigilantes.com/?p=16264Emerging markets debt posted strong returns in 2017, driven by the stabilisation of fundamentals, ongoing global and EM economic recovery, a small rebound in commodity prices and a geopolitical environment in which the usual suspects (Trump, North Korea, China) have behaved in a more benign fashion thus far. One had to struggle to find an asset that produced negative returns and the only two th…]]>Emerging markets debt posted strong returns in 2017, driven by the stabilisation of fundamentals, ongoing global and EM economic recovery, a small rebound in commodity prices and a geopolitical environment in which the usual suspects (Trump, North Korea, China) have behaved in a more benign fashion thus far. One had to struggle to find an asset that produced negative returns and the only two that did, Venezuela and Turkish local bonds, reflected very different idiosyncratic factors.

Here is a recap of what happened last year and some views for the year ahead:

Asset allocation was a driver of performance

The US Dollar peaked exactly at the beginning of the year, which allowed EM local currencies to perform well. Developed currencies also posted strong returns versus the US Dollar, particularly the Euro, as the market priced out a more hawkish Fed and a stronger fiscal stimulus in the US and the continuation of a broad based recovery in Eurozone growth. This, combined with a small uptick in commodity prices and disinflation in many EM countries, allowed most currencies to rally versus the US Dollar, though many did not outperform the Euro.

For 2018, local markets may still outperform external debt given relative valuations on both, but I expect lower returns in 2018 as a fair amount of good news has been priced into EM assets. The chart above shows that economic data surprises in EM are moderating, meaning that the uplift in growth that we have been highlighting for over a year may be mostly priced in by now. Additionally, the disinflation we have seen in several EM countries in 2017 (Brazil, Russia, Colombia, etc.) is unlikely to extend into 2018 as the base effects fade away and the bulk of policy rate easing in EM is behind us. Finally, should the Fed prove to be behind the curve (2-3 hikes are currently priced in for 2018), this is not yet priced in and would provide support for the US Dollar.

EM corporates underperformed, partly due to their lower duration than EM sovereigns but also due to their increasing investment grade component, which will normally underperform in a rally. Chinese investment grade credits continued growing in importance due to strong supply and demand from onshore investors.

In the hard currency space, higher beta countries outperformed

The higher beta countries outperformed and the performance of their proxy, the EM frontier index, returned 15.7%, pretty much in line with the returns on local market bonds. With the exception of distressed credits (Belize on the upside and Venezuela on the downside), returns were often similar for countries whose fundamentals are improving (e.g. Egypt or Jamaica), as well as the ones that are deteriorating (e.g. Tunisia or Costa Rica).

This reflects some indiscriminate hunt for yield and beta and the need to remain invested, as inflows into the asset class have persisted through the year. A few elections (Mexico, Brazil being the most pertinent) will shape the direction of those countries that happen to be at a critical juncture.

Looking ahead into 2018, this may still continue as long as the inflows remain steady, but I expect to see more differentiation of returns given that we are starting from tighter valuations. In other words, beta will still be an important call in 2018, but alpha should become more relevant again after a relatively muted 2017.

The strong returns we saw in 2017 are unlikely to be repeated in 2018. However, should the tail-risks (US economic policy and the Fed, China, geopolitical risks and EM elections, etc.) remain on the backburner and volatility remain contained, the EM carry of 5.5-6.5% is not too shabby, especially considering the investment alternatives in other parts of global fixed income.

Beyond the human tragedy and economic costs, these are typically low-probability, but potentially high-impact, events that can ultimately impact an issuer’s ability to service its debt obligations. As bond investors, we aim to assess the various risk factors related to the companies …

]]>First of all, our thoughts are with those impacted by Hurricane Irma and other recent weather-related disasters.

Beyond the human tragedy and economic costs, these are typically low-probability, but potentially high-impact, events that can ultimately impact an issuer’s ability to service its debt obligations. As bond investors, we aim to assess the various risk factors related to the companies we invest in and, ultimately, decide whether we are being well enough compensated for taking those risks.

The chart above lists a sample of USD-denominated bonds of at least USD 100 million issued by various Caribbean countries, where Grenada provides one interesting case study. Grenada, a small and largely tourism-based economy, was hit by Hurricane Ivan in 2004, only two years after its international bond market debut with a sovereign issue maturing in 2012. The damage was widespread, estimated at almost 150% of GDP, impacting physical infrastructure, housing (where only a small portion of the housing stock was insured), agriculture and tourism. The country ended up defaulting and restructuring its bonds with a haircut of approximately 40%.

Delving into the detail of Grenada’s prospectus for that particular bond, we find that it did state that ‘Grenada lies south of the usual track of hurricanes, but when storms do occur, as in 1955, 1979 and 1980, they often cause extensive damage. A major hurricane or other climatic or geological occurrence could have a material adverse effect on Grenada and, as a result, the Government’s financial condition and its ability to meet its debt service and other obligations, including with respect to the note’. For a prospectus that was 94 pages long, with an extensive assessment of Grenada’s economic, geographic and environmental conditions, one may be surprised to see the word ‘hurricane’ appear only twice and the broader word ‘disaster’ just get 15 mentions.

The IMF has recently published a very comprehensive study around the associated costs of hurricane impacts in the Caribbean region. Surprisingly it states that economic damages could be underestimated by material amounts, with the average damage per island potentially being as large as 82% of GDP .

Furthermore, this map comes to show how hurricanes can indeed affect most Caribbean countries, with only very few (i.e. Aruba or Belize) falling outside the main hurricane belt. With this in mind, I would argue that prevailing sovereign bond yields for many of these economies are currently not pricing in a worst-case scenario of being hit by a large-scale weather-related disaster. As in the case of any fat-tail event, caveat emptor.

]]>https://www.bondvigilantes.com/blog/2017/09/13/caribbean-bonds-forecasting-weather-tail-risks-spreads/feed/0Argentina’s century bond: much ado about nothinghttps://www.bondvigilantes.com/blog/2017/06/23/argentinas-century-bond-much-ado-nothing/
https://www.bondvigilantes.com/blog/2017/06/23/argentinas-century-bond-much-ado-nothing/#commentsFri, 23 Jun 2017 09:11:43 +0000https://www.bondvigilantes.com/?p=15566Argentina’s recently issued century bond deal was unexpected in terms of timing and maturity. Century bonds in Emerging Markets (EM) are rare (we think the table below is pretty exhaustive) and they grab the headlines, especially when issued by a credit that has defaulted many (many) times, like Argentina.

]]>Argentina’s recently issued century bond deal was unexpected in terms of timing and maturity. Century bonds in Emerging Markets (EM) are rare (we think the table below is pretty exhaustive) and they grab the headlines, especially when issued by a credit that has defaulted many (many) times, like Argentina.

Are century bonds that much risker?

Duration: As we wrote previously, the duration of century bonds is not much longer than the duration of 30-year bonds, which themselves are quite common amongst emerging markets, including Argentina.

Implied probability of default. Another way to measure the risk of this bond is to calculate its implied probability of default. Using a standard ISDA model, we assigned a 30% recovery value (similar to the last Argentinean default in 2001) and the term premia of the recently issued century bonds (T+ 515 bps) to extrapolate the spread curve. Under these assumptions (ignoring any CDS-bond basis), the probability of default is as per below:

Given the unusual maturity of the bond, the model choked after 50 years. However, we can see that the implied probability of default given these assumptions is already at 97% for a bond maturing in 50 years. Given this, a century bond should not be seen as being much riskier. In other words, the current level of Argentinean spreads is at an unstable equilibrium: either fundamentals will continue improving and credit spreads will continue to fall over the next decades or history will repeat itself, fundamentals will not improve and Argentina will default again. In this latter scenario, it almost does not matter then whether you are holding a 50-year bond or a century bond.

‘In the long run we are all dead’ John Maynard Keynes

To conclude then, the duration of a 30 year Argentinian bond at 11.8 years is little different to that of a century bond (12.7 years), so spread risk is not significantly higher. The default risk of a 30 year bond is close to 100% anyway given current pricing of long term Argentinian risk – how much worse can it be in a 100 year bond?

What about the prospects for Argentina’s economy?

In terms of fundamentals, Argentina’s new administration is trying to address deep challenges that were inherited from the prior administration. There has been rapid progress on liberalizing capital controls and they have unified the currency market under a new floating exchange rate regime. Relations with investors have improved markedly and this bond attests to that. On the domestic side, however, the improvements have been more gradual. Inflation (measured by the City of Buenos Aires CPI) is declining as the pass-through the Peso depreciation dissipates but is still hovering above 20%.

Growth is picking up, led by investment, and this will be critical in addressing two of Argentina’s medium term risks:

The fiscal position remains very weak, with a deficit of over 6% of GDP. This means that Argentina still depends largely on the external markets to finance these deficits as the domestic market cannot fund it all. Higher and sustained levels of growth will be required to improve the fiscal dynamics through higher revenues and allow for political room to continue reducing some rigid expenditures, including subsidies on tariffs and transport.

The key risk is the sustainability of Macri’s market-friendly and orthodox economic policies. An initial test will be the outcome of the midterm elections this October, but the litmus test will be the presidential elections in 2019. In absence of economic improvements, higher growth, lower inflation and improvement of real wages, the return of populist policies should the Peronist party start recovering lost ground and win the 2019 elections cannot be ruled out. That will be very bearish for asset prices.

]]>https://www.bondvigilantes.com/blog/2017/06/23/argentinas-century-bond-much-ado-nothing/feed/4The Israeli Shekel: Flying under the radarhttps://www.bondvigilantes.com/blog/2017/05/03/israeli-shekel-flying-radar/
https://www.bondvigilantes.com/blog/2017/05/03/israeli-shekel-flying-radar/#respondWed, 03 May 2017 08:10:13 +0000https://www.bondvigilantes.com/?p=15372Though the recent US Treasury report did not name any country as a currency manipulator (see more details on this in Mario’s blog), the monitoring list centres on larger economies that meet the following criteria:

The country has a significant bilateral trade surplus with the United States defined as more than USD 20 billion.

The country has a current account surplus of at least 3% of GDP and …

]]>Though the recent US Treasury report did not name any country as a currency manipulator (see more details on this in Mario’s blog), the monitoring list centres on larger economies that meet the following criteria:

The country has a significant bilateral trade surplus with the United States defined as more than USD 20 billion.

The country has a current account surplus of at least 3% of GDP and would therefore receive heightened analysis from the U.S. Treasury.

A persistent, one-sided currency intervention in excess of 2% of a country’s GDP over a 12-month period could be a sign that a country is manipulating its currency.

Because Israel is a much smaller economy (estimated $318 billion at the end of 2016) and not a major trading partner with the US (bilateral trade surplus is far less than $20 billion), it is not included on the monitoring list. Anecdotally however, if one were to examine the other factors that are part of the monitoring criteria, Israel would likely have joined the club.

The Bank of Israel conducts monetary policy using a combination of interest rate and currency interventions. Inflation and inflation expectations are now approaching the lower end of the 1-3% target (after a two year deflationary period) and the economy is growing at a solid pace. There is room for monetary policy to remain accommodative, but I think it unlikely that interest rates will be reduced into negative territory from the current 0.1% base rate, now that inflation is heading in the right direction.

The Bank of Israel perceives the Shekel to be moderately overvalued and has been intervening in the currency markets to smooth the appreciation and in more recent years, to neutralize the flows coming from gas exports, in others to mitigate the risk of Dutch disease. The IMF, on the other hand, believes that the currency is roughly in line with fundamentals. There are, however, conflicting results depending on the FX model methodology used, as it is often the case when attempting to model currencies. Some models suggest a 15% undervaluation, while others suggest a modest 4% overvaluation. See page 50 here for more details.

The Shekel could be an interesting opportunity for currency investors (not concerned over additional USD strength) that believe that the favourable trends in the balance of payments remain intact, that the Bank of Israel will not increase the pace of currency interventions and that there is no scope for additional monetary easing.

]]>https://www.bondvigilantes.com/blog/2017/05/03/israeli-shekel-flying-radar/feed/0China Renminbi: the USD $50,000 questionhttps://www.bondvigilantes.com/blog/2017/01/10/china-renminbi-usd-50000-question/
https://www.bondvigilantes.com/blog/2017/01/10/china-renminbi-usd-50000-question/#commentsTue, 10 Jan 2017 08:50:28 +0000https://www.bondvigilantes.com/?p=14964Last week, in line with expectations, China announced the renewal of the $50,000 limit of dollar purchases by individuals. What’s changed however is that the foreign exchange commission (SAFE) has tightened the scrutiny on the foreign exchange purchases. Applicants are now required to detail the purpose behind their transactions in order to ensure that the purchase is for “suitable purposes” (e…]]>Last week, in line with expectations, China announced the renewal of the $50,000 limit of dollar purchases by individuals. What’s changed however is that the foreign exchange commission (SAFE) has tightened the scrutiny on the foreign exchange purchases. Applicants are now required to detail the purpose behind their transactions in order to ensure that the purchase is for “suitable purposes” (e.g. overseas studies, outbound tourism, business abroad, overseas medical treatment, the purchase of non-investment insurance and consulting services), adding a new layer of bureaucracy, in an attempt to reduce the purchases.

I was in Hong Kong on a business trip last year, opining on China’s regime and capital controls with an analyst. During our discussion I touched upon my blog where I put the capital outflows into perspective by calculating the appropriate level of international reserves by looking at a common metric, the Assessing Reserve Adequacy ratio (ARA), which measures reserves versus debt levels, monetary aggregates and trade. This time around, I’m making things simpler by answering a straightforward question:

If 1% of the population decides to buy $50,000, how does this measure up versus a country’s actual international reserves?

At first glance, China’s potential retail USD demand, at 23% of foreign exchange reserves, is not too far off the 28% median result. However, the countries are not homogeneous. Indeed, most countries with a floating currency regime have an open capital account. It’s also important to note that the exercise includes countries with large current account surpluses, such as Korea and Israel, which have in the past accumulated large amounts of reserves through past interventions to prevent further currency appreciation[i]. Finally, countries such as India have a large population but low per capita income (see final column in the table). Therefore although we do not have details on the per capita income skew beyond Gini coefficients (so it is difficult to estimate how easy it is for 1% of Indian citizens to tap into $50,000 worth of savings), in all likelihood, it will be more difficult to do so than, say, the Indonesians.

Countries with a fixed exchange regime and an open capital account need to have much higher reserve buffers, which is precisely what the table indicates, with this measure coming in much lower at 1-3.

China finds itself somewhere in the middle. It does not have a free floating regime and the capital account restrictions remain significant. Corporate debt levels are very high, so tightening monetary policy aggressively to make Renminbi assets more attractive is not an easy option. With a high level of household savings (there is no household savings data for all countries, so I omitted this relevant fact in my calculations, but China potentially has the highest household savings of the countries listed), the pent-up USD demand will linger as long as there is the perception that inflow and outflow of dollars remain imbalanced. On a cheerier note, the gradual changes to China’s currency regime are moving in the right direction, towards a more flexible arrangement[ii]. But based on the crude metrics above, a free floating currency with full capital mobility is still a long-term prospect.

The Chinese new year is fast approaching and we will soon be celebrating the year of the Rooster, let’s hope that the tighter capital controls calm things down so that the chickens do not come home to roost.

[i] Should Mr Trump decide to label a country as a currency manipulator, the US Treasury should be targeting countries like Korea, not China. Korea remains on the US Treasury monitoring list. See here for more details on the monitoring criteria.

[ii] PBoC just announced a reweighting of its CFETS currency basket index to include 11 additional currencies, namely the KRW and a few other EM currencies, which will help to reduce the CNY broad appreciation should USD strength continue or should, for example, Korea be labelled a currency manipulator by the US Treasury.

]]>https://www.bondvigilantes.com/blog/2017/01/10/china-renminbi-usd-50000-question/feed/2Emerging market debt: 2016 post-mortem and 2017 outlookhttps://www.bondvigilantes.com/blog/2017/01/05/emerging-market-debt-2016-post-mortem-2017-outlook/
https://www.bondvigilantes.com/blog/2017/01/05/emerging-market-debt-2016-post-mortem-2017-outlook/#commentsThu, 05 Jan 2017 09:14:43 +0000https://www.bondvigilantes.com/?p=14939Despite a year of high political turmoil – which of course included the UK EU referendum and the US elections – emerging market assets proved surprisingly resilient to the various global events, even with rising core government yields in the second half of 2016. Given that starting valuations at the beginning of the year, both with respect to credit spreads as well as currencies, were pricing …]]>Despite a year of high political turmoil – which of course included the UK EU referendum and the US elections – emerging market assets proved surprisingly resilient to the various global events, even with rising core government yields in the second half of 2016. Given that starting valuations at the beginning of the year, both with respect to credit spreads as well as currencies, were pricing in quite a bit of negative news, this initial cushion allowed the asset class to navigate the year relatively well. The return of inflows into the asset class following the Brexit vote and the recovery of commodity prices, particularly oil, also helped spreads to tighten. Below, I give a run-down of the year just gone and highlight my key calls for emerging markets in the year ahead.

Asset allocation was not a major driver of performance

Total returns were almost identical for hard currency, local currency and corporates in 2016. In last year’s outlook, I surmised that asset allocation would not be a predominant driver for the asset class and I expect this trend to continue into 2017. Instead, I expect that a call on beta and overall risk will be more important than the asset allocation given starting valuations being less generous this year, particularly in hard currency sovereigns and corporate spreads.

Currency valuations provide some cushion to a stronger USD

Currencies, for the most part, are in the range of fairly valued to somewhat undervalued and this provides a cushion for a stronger dollar environment, fuelled by higher rates in the US. The recent recovery in oil prices is additionally supportive for currencies such as RUB and MYR and there is quite a bit of bad news priced into MXN, but I do not believe there will be material changes to NAFTA from the upcoming US administration.

Higher oil prices take some pressure off the pegged Gulf cooperation currencies, as this will allow the region to continue borrowing at more favourable rates in the international markets, as tighter spreads partly offset higher US yields.

The current account adjustment is well underway (or complete in many EM countries), with some notable exceptions such as Turkey and South Africa. The big elephant in the room however is the Chinese Yuan Renminbi, which continues to be vulnerable to capital outflows and potentially negative news should the incoming US administration pursue unfriendly trade policies and/or name China a currency manipulator. While my base case scenario does not contemplate the floating of the currency in 2017, it remains a tail-risk to be mindful of.

Local markets produced a wide dispersion of returns, both in terms of FX returns as well as yields, but this dispersion should be much less pronounced in 2017.

Spreads tightened, particularly in commodity credits and Brazil

2016 proved to be the mirror image of 2015. In countries such as Brazil and Argentina, the recovery of commodity prices and perceived improvement in the political climate led to a large rally in these credits. In fact, with the exception of Ukraine, all top performers in 2016 were the previously weaker performing lower-rated commodity credits.

At the other end of the spectrum, Mozambique and Belize announced restructurings in 2016 and as such, the likelihood of any additional sovereign credit events is centred on Venezuela, which stands out as the binary call for 2017. The country, once again, will prove to be either the best performing credit if they do not default, or the worst if they do. With the prospect of political change and more pragmatic economic policies dimming, the chances of a Venezuelan credit event have increased in 2017, as rising oil prices are still not enough to close the financing gap. On the whole however, given that there are fewer sovereign credits at risk of default in 2017, return dispersion and bottom-up differentiation within emerging markets should therefore be less extreme this year.

Brazil will not be the outperformer in 2017 as existing valuations are priced for a perfect execution of policy. More importantly, the outperformers of 2016 will not generate double digit returns as this would require them to trade at unrealistic spread levels, i.e. some 200-300 bps of additional tightening. Instead, I expect more moderate mid-single digit returns, basically in line with the carry.

Idiosyncratic risks continue with developed markets in 2017

Politics and economic policy developments in the US, as well as key elections in Europe are the major foreseeable events to be digested in 2017. Monetary normalization continues in the US and treasury yields, while not cheap on a long-term basis, have at least adjusted closer to fair value in the near term and should prove to be less of a headwind to returns in 2017. This is relevant as spread returns should be much lower than 2016 as well.

I expect asset allocation between hard and local currency to remain a small driver in 2017. Bottom up hard currency and local currency selection will remain somewhat important, but with a much smaller return dispersion than in 2016. Instead, a call on beta and overall risk will be more important given starting valuations.

]]>https://www.bondvigilantes.com/blog/2017/01/05/emerging-market-debt-2016-post-mortem-2017-outlook/feed/1The US election result impact on emerging marketshttps://www.bondvigilantes.com/blog/2016/11/09/us-election-result-impact-emerging-markets/
https://www.bondvigilantes.com/blog/2016/11/09/us-election-result-impact-emerging-markets/#respondWed, 09 Nov 2016 10:18:58 +0000https://www.bondvigilantes.com/?p=14331Today’s US election result has several implications for emerging markets. At a first glance, the outcome is clearly negative, given the potential downside risks from increased trade protectionism, anti-immigration measures, large fiscal expansion and steepening of the US yield curve and uncertainty in terms of foreign policy.

These risks are already being reflected in asset prices. Since the re…

]]>Today’s US election result has several implications for emerging markets. At a first glance, the outcome is clearly negative, given the potential downside risks from increased trade protectionism, anti-immigration measures, large fiscal expansion and steepening of the US yield curve and uncertainty in terms of foreign policy.

These risks are already being reflected in asset prices. Since the result, Mexico is one of the largest underperformers due to its deep trade and economic ties to the US. Another region which could suffer is Central America. If Trump goes ahead with all of his proposals during the campaign and manages to overcome the logistical nightmare of having all illegal immigrants deported, remittances from these immigrants will come to an end and that will certainly have an impact on their home countries’ economies. In Central America, countries seeing the largest impact would be the smaller ones, such as Guatemala, El Salvador and Honduras, where unauthorised remittances from the US could account for as much as 5.6%, 8% and 13.2% of their respective GDPs, according to our estimations. These countries have a much higher share of remittances vs. GDP and current account receipts because their share of illegal immigrants is higher in comparison to the size of their economies and population (see my previous blog on this topic here).

However, as is always the case, volatility creates opportunities. There are several countries that are relatively closed economically, such as India and Brazil, that have relatively low trade or immigration ties with the US. Countries within Eastern Europe are much more dependent on Europe than the US for their exports or financial channels. In this respect, they will be much more impacted by the upcoming Italian, French and German political events than the US election. Russia may benefit from today’s result should the US start easing financial sanctions. Finally, commodity credits such as Sub-Saharan African issuers are much more dependent on China as a driver for commodity demand or for financing than the US. In terms of relations with China, imposition of trade tariffs and whether the US Treasury will name China as a currency manipulator will be the key events to watch.

We will look to selectively increase exposure to countries that have relatively looser ties with the US and whose asset prices have been unduly punished or for assets that have severely underperformed, such as the Mexican Peso, which is finally pricing in a lot of negative news after a 50% depreciation in the last two years.

]]>https://www.bondvigilantes.com/blog/2016/11/09/us-election-result-impact-emerging-markets/feed/0Case study: Could Trump’s brand affect bond prices?https://www.bondvigilantes.com/blog/2016/08/16/case-study-trumps-brand-affect-bond-prices/
https://www.bondvigilantes.com/blog/2016/08/16/case-study-trumps-brand-affect-bond-prices/#respondTue, 16 Aug 2016 08:35:15 +0000https://www.bondvigilantes.com/?p=13821Earlier this year I gave a top-down macro assessment of Trump’s potential impact on Latin American remittances, should he become President. As the race continues, I now take a bottom-up micro view and assess Trump’s potential impact on an individual bond issue associated with the Trump Organization.

]]>Earlier this year I gave a top-down macro assessment of Trump’s potential impact on Latin American remittances, should he become President. As the race continues, I now take a bottom-up micro view and assess Trump’s potential impact on an individual bond issue associated with the Trump Organization.

In 2007 the Panamanian real estate market was growing robustly, with prices experiencing double-digit growth. Given this backdrop, Trump Ocean Club’s $220 million bonds were issued in November 2007 through Bear Stearns and were initially rated Ba3 by Moody’s and BB by Fitch. The amount raised was used to finance the development of a high-end project in Panama, comprising of condominiums, a hotel, a casino and some shops and office space.

The developers – a Panamanian-Colombian controlled holding company – entered into a licensing agreement with the Trump Organization for the rights to use the Trump name for a fee of approximately $75 million (which was based on initial assumptions on gross sales). At the point of issue, the project was 64% pre-sold and it was expected that the rest would be sold by 2010. Given the timing of events, however, various factors contributed to difficulties. First and foremost was the US real estate crisis and the aftershocks of the Lehman collapse, which spilled over to the region. Panama is a dollarised economy, but a material share of the committed buyers were from countries whose currencies depreciated significantly, including Venezuela, Colombia and Canada, which led to some buyers defaulting on their purchase agreements. As of early 2015, just 74% of the units were sold. In addition to the adverse macro backdrop, cost overruns ended up stretching the issuer’s ability to service the bonds.

The bond defaulted in 2012 and was exchanged for a new security with a maturity extension until 2017. The new bonds are in default again, though the issuer has made some interest payments and partial tenders at low prices. It remains quoted at distressed levels.

The Trump branding continues to be used, despite the fact that the issuer has not fully honoured its financial commitments (for the name licensing fee) to the Trump Organization and the matter is under litigation. The bond issuer evidently places great value on the Trump name (the prospectus highlights “a decrease in the perceived prestige of the Trump brand name…could adversely impact our ability to market and sell our products”, as the brand was intended to “enhance the marketing and sale of our real estate products to affluent individuals”). As such, Trump’s controversial statements through his campaign could arguably have a negative impact on the brand image, and potentially on the property valuations as end-buyers shy away from the Trump-branded development in favour of other developments in Panama City. This could potentially lead to a larger proportion of the units going unsold, or being sold to investors at discounted prices.

Meanwhile in the US, building on this idea, the app Foursquare has attempted to quantify the amount of foot traffic into Trump-branded US properties over the last 1.5 years based on data sourced from its users. Foursquare found that the market share of foot traffic to Trump US properties in 2015-16 has fallen compared to 2014-15 by approximately 10-15%, particularly among women and Democratic states, which displayed even more pronounced declines (they have adjusted the data to account for the relative number of visits to Trump-branded properties versus visits to competing properties, so it reduces one-off factors such as weather-related issues. They also looked at the absolute number of visits to measure if the decrease in Trump properties’ market share was not due to one-off increases of visits to competitor properties). While these statistics are far from scientific, they do provide some food for thought.

As always, avoiding tail risk underperformers at this part of the cycle (i.e. of rising corporate and sovereign defaults) remains key for long-term performance. Bond investors have an additional reason to keep an eye on Trump.

]]>https://www.bondvigilantes.com/blog/2016/08/16/case-study-trumps-brand-affect-bond-prices/feed/0The Central American Remittance Crunch – who would lose most from a Trump Presidency?https://www.bondvigilantes.com/blog/2016/03/14/the-central-american-remittance-crunch-who-would-lose-most-from-a-trump-presidency/
https://www.bondvigilantes.com/blog/2016/03/14/the-central-american-remittance-crunch-who-would-lose-most-from-a-trump-presidency/#commentsMon, 14 Mar 2016 09:40:09 +0000https://www.bondvigilantes.com/?p=13310The US election campaign has surprised everyone thus far. Candidate Donald Trump has vowed to deport all of the 11 million illegal immigrants currently living in the US. He has also declared that he would impound all remittance payments derived from illegal wages. We have written before how Central America and the Caribbean would benefit from improving US growth and have been invested in variou…]]>The US election campaign has surprised everyone thus far. Candidate Donald Trump has vowed to deport all of the 11 million illegal immigrants currently living in the US. He has also declared that he would impound all remittance payments derived from illegal wages. We have written before how Central America and the Caribbean would benefit from improving US growth and have been invested in various sovereigns in the region as a result. Remittances benefit receiving countries as they reduce their current account deficits and have a positive impact on domestic consumption and growth, although studies have also pointed out some negative impact through increasing income inequalities or potential for currency appreciation, making exports less competitive.

Assuming that Trump was to become President and – logistics and feasibility aside – that all the illegal immigrants be deported, how will this impact the region’s remittance flows? In the table below we used total migrant population data from the Migration Policy Institute and estimates of illegal migrants from the Center for Migration Studies to calculate the ratio of illegal to legal migrants for each country. We then assumed the same ratio to calculate the volume of unauthorised remittances, using total remittance data from the World Bank. In reality there are differences between legal vs illegal worker remittance volumes as well as the length of time they are sent for, and the accuracy of the illegal migrant data could also be questioned.

The focus of the rhetoric has centred on Mexico, as it has the largest absolute number of immigrants in the US. However, as can be seen in the table, the biggest losers would be the smaller countries of El Salvador and Honduras. Both have a much higher share of remittances vs. GDP and current account receipts because their share of illegal immigrants is higher in comparison to the size of their economies and population.

Mexico, instead, would be much more negatively affected should the existing NAFTA free-trade agreement be renegotiated, as its economy is much more dependent on exports to the US than worker remittances.

Clearly, there are other broader implications that are much harder to quantify. Larger current account deficits would lead to a combination of weaker currencies, higher debt levels and nominal price deflation in the case of dollarized El Salvador. Growth could also be lower if the increased workforce is not able to find similar opportunities at home, which would be negative for their fiscal accounts and debt dynamics. Let’s hope that common sense and the impracticality of deporting 11 million people prevails in the end.

]]>https://www.bondvigilantes.com/blog/2016/03/14/the-central-american-remittance-crunch-who-would-lose-most-from-a-trump-presidency/feed/1How long until China reaches the floor of the recommended reserve adequacy range?https://www.bondvigilantes.com/blog/2016/02/11/how-long-until-china-reaches-the-floor-of-the-recommended-reserve-adequacy-range/
https://www.bondvigilantes.com/blog/2016/02/11/how-long-until-china-reaches-the-floor-of-the-recommended-reserve-adequacy-range/#respondThu, 11 Feb 2016 10:50:49 +0000https://www.bondvigilantes.com/?p=13234Much has been discussed on the topic of the optimal level of foreign exchange reserves. One of the common methodologies is the IMF’s ARA (Assessing Reserve Adequacy) metric, which essentially provides a range based on a country’s trade, broad monetary aggregates and external liabilities. How much weight should be given to each factor varies according to the economic structure of each country, i…]]>Much has been discussed on the topic of the optimal level of foreign exchange reserves. One of the common methodologies is the IMF’s ARA (Assessing Reserve Adequacy) metric, which essentially provides a range based on a country’s trade, broad monetary aggregates and external liabilities. How much weight should be given to each factor varies according to the economic structure of each country, including whether it is a relatively open or closed economy in terms of trade and capital flows and whether the exchange rate is floating or not. Based on past EM crises, the IMF has recommended a range which is normally expressed in terms of 100-150% of the metric. The ongoing pressures on the Renminbi and China’s attempt to smoothen its depreciation through currency intervention beg the question of how much firepower China has, given declining reserves.

Using the IMF’s standard framework, we calculate that China has approximately 6-7 months until it reaches the lower bound of the recommended range (100%). Arguably, this includes several large assumptions, including that the ongoing capital flight and reserve loss (at around $100 billion per month) and current account surplus remain at the same pace. We also do not know how much intervention there actually has been in the currency forward market, and some data, like debt stocks, are reported only quarterly with a lag (the last data is from September).

Any policy response from the authorities is likely to aim for faster depreciation of the Renminbi than we have seen so far, though we do not expect a large one-off move. That would require a strong coordination with global central banks to minimise financial contagion, given China’s systemic impact on global markets, and we do not think we are there yet. Tighter capital controls for residents have been gradually adopted and this is the most likely policy option in the near term, but is never 100% effective. Higher rates and tighter domestic liquidity would be problematic, given China’s large domestic debt levels.

In the spirit of the Chinese New Year – and wishing all our readers a rally monkey – we hope that our calculations are wrong and China has far more time than 6 months. For one, the number 6 is thought to be an unlucky number in Cantonese – it has a similar pronunciation to that of “lok6” (落, meaning “to drop, fall, or decline”), quite apropos.

]]>https://www.bondvigilantes.com/blog/2016/02/11/how-long-until-china-reaches-the-floor-of-the-recommended-reserve-adequacy-range/feed/0Emerging Markets debt: 2015 returns post-mortem and 2016 outlookhttps://www.bondvigilantes.com/blog/2016/01/07/emerging-markets-debt-2015-returns-post-mortem-and-2016-outlook/
https://www.bondvigilantes.com/blog/2016/01/07/emerging-markets-debt-2015-returns-post-mortem-and-2016-outlook/#respondThu, 07 Jan 2016 13:52:24 +0000https://www.bondvigilantes.com/?p=13059Following on from Gordon’s review of the best and worst performing fixed income asset classes last year, I wanted to take a more in depth look at how emerging markets performed in 2015 and what to look out for in 2016.

Some themes that drove the market in 2015 were the same themes than drove it in 2014. Once again, asset allocation was critical. Local currency debt, for the third year running, …

Some themes that drove the market in 2015 were the same themes than drove it in 2014. Once again, asset allocation was critical. Local currency debt, for the third year running, has underperformed hard currency debt. Within hard currency, sovereigns and corporates performed roughly in line at the broad index level.

However, as I wrote a year ago, return dispersion did increase in 2015 and avoiding the tail-risk underperformers was key. These were the main themes from 2015:

1. Duration was not a major driver of performance

Although the Fed has finally started tightening US monetary policy, 10-year Treasury yields ended 2015 just marginally higher, as the market had long been expecting, and pricing in, such a move. As long as the Fed delivers what is currently priced in by the markets in 2016 (i.e. 50-75 bps tightening), I expect emerging markets to be able to cope considering they have already been adjusting to this for a few years through weaker currencies, reduced capital inflows and more expensive funding costs.

2. Currency depreciation continued, but the good news is that it should not be as bad in 2016

As the table above illustrates, much of the underperformance in local currency debt came from currency moves, though some of this is still about USD strength and not necessarily an emerging market move in itself. In other words, many EM currencies performed in line or even better than major currencies such as the euro or commodity currencies such as the Australian (AUD) and Canadian Dollar (CAD). I expect the USD to start stabilizing in 2016, based on past Fed tightening cycles when a large part of the USD appreciation happened before the first hike. This year’s local currency underperformance suggests that many EM currencies are no longer overvalued and, in cases such as the Polish Zloty, the Hungarian Forint or the Chilean Peso, has led to an improvement of current account balances or will allow for an ongoing adjustment such as in the case of Brazil. Fixed and heavily managed currencies, however, remain vulnerable to low oil prices (i.e. GCC pegs, Nigerian Naira). Perhaps the most critical of all is the Renminbi, where Chinese authorities face a difficult trade-off between maintaining the status quo of low volatility and some degree of overvaluation or allowing a faster devaluation that risks a disorderly spill-over into Asian and commodity-related currencies.

3. Spreads widened, particularly in commodity related credits

Like 2014, spread performance was again a tale of two halves. As the chart below illustrates, even though many EM countries are actually net commodity importers, overall spreads have shown a relatively high correlation to commodity and oil prices this year (Charles will explore this in greater depth in another blog to be published shortly). Overall, I believe that spreads are already reflecting a large part of the credit deterioration that we have seen in recent years but do not expect them to tighten as it is unlikely that we see any major credit improvements in the near term. However, that could change if we were to witness a rebound in commodity prices, or the Fed signalled that the tightening cycle will be very shallow.

4. Idiosyncratic risks remain elevated and will not subside in 2016

Several of the top performing countries in 2015 are distressed credits that avoided defaulting (i.e. Venezuela, Belarus). Ukraine’s returns benefitted from a benign restructuring, Russia recovered from the oversold levels of 2014 as the conflict with Ukraine did not escalate and Argentina rallied on the prospect of a more market-friendly Macri government. Most of those cases, however, are unlikely to be the main outperformers in 2016 as the trigger for additional good news is less likely and valuations are also more expensive after the 2015 rally. Venezuela remains a binary credit; it will either be one of the top performers this year if they do not default, or one of the worse, if they do. The opposition victory in the recent assembly elections is positive, but not enough to remove large uncertainties over the country’s economic policy direction under low oil prices.

In terms of the worst performers, Brazil will be one of the key calls for 2016. As discussed in a prior blog entry, I remain cautious on the credit given the large political headwinds, which will make an economic and fiscal recovery more difficult. Sub-Saharan Africa remains under pressure from low commodity prices and a debt burden that is increasing rapidly in most countries given their large fiscal deficits and, in some cases, large currency depreciations. While there is little debt roll-over risk in 2016, that will start rising in a few years’ time when I would expect to see some credit events. The willingness to adjust and pay will be tested and we do not have a long track record of bonded debt repayment and recovery values as most bonds have been issued over the last few years.

In sum, I expect asset allocation between hard and local currency to remain a smaller driver in 2016, as currency depreciations finally stabilize. Sovereign and corporate credit selection within the hard currency space will remain critical as I expect return dispersion to become high. Finally, avoiding the tail-risk underperformers and corporate defaults will be a key call for emerging market investors in 2016.

]]>https://www.bondvigilantes.com/blog/2016/01/07/emerging-markets-debt-2015-returns-post-mortem-and-2016-outlook/feed/0Colombia: At risk of a rating downgrade to BBB-https://www.bondvigilantes.com/blog/2015/11/04/colombia-at-risk-of-a-rating-downgrade-to-bbb/
https://www.bondvigilantes.com/blog/2015/11/04/colombia-at-risk-of-a-rating-downgrade-to-bbb/#respondWed, 04 Nov 2015 15:40:10 +0000https://www.bondvigilantes.com/?p=12779Part of theABC of Latin American debt series (see here for views on Argentina and here for Brazil)

During my recent trip to Latin America it was funny (but not surprising) to hear the locals worrying about Colombia becoming the next Brazil. In turn, Brazilians are worried about becoming Argentina (though I believe the Argentinean problems are much more solvable in the near term than Brazil’s) …

]]>Part of theABC of Latin American debt series (see here for views on Argentina and here for Brazil)

During my recent trip to Latin America it was funny (but not surprising) to hear the locals worrying about Colombia becoming the next Brazil. In turn, Brazilians are worried about becoming Argentina (though I believe the Argentinean problems are much more solvable in the near term than Brazil’s) and Argentineans believe they are a world apart from Venezuela (still true, but if they get four more years of policy inaction, it will go that route as well). It reminds me of the height of the Eurozone crisis when the Portuguese were telling us they were not Greece, Spain was not Portugal and so on.

Colombia’s starting point is much healthier than Brazil’s in terms of debt levels, fiscal position and the political environment. However, it does have some similarities that, if not addressed within the next few years, could put the country into a difficult position. Both countries (and Argentina as well) have fiscal challenges and little additional space to raise taxes. Any fiscal improvements will need to come through spending cuts from politically-sensitive earmarked items, as discretionary spending and infrastructure spending has already been reduced to minimum levels. Approximately 1-2% GDP is needed to replace the shortfall in oil-related revenues and large scale tax reforms will need to be approved by the middle of next year, before the next electoral cycle kicks in. The social security system also needs reform. Infrastructure (roads, public transport, etc.) in the region is very poor (Colombia ranks particularly poorly here) and most countries are hoping for public-private partnerships to help fill the gap.

A rebound of growth in the medium-term will also help, but in the short-term growth is under pressure from various shocks: terms of trade and the oil price decline, supply-side inflation pressures (especially if El Nino turns out to be a strong one), a much weaker currency, which is acting as the shock absorber, and potential tax hikes. On the positive side, the peace process between the Colombian government and the FARC could deliver a 0.3-0.5% increase in potential growth over the medium to long term.

I returned from my trip more cautious than the authorities and the IMF on their near term assessment (see chart above). I see downside growth risks coming from falling consumption as purchasing power declines over the next 1-2 years. I am also concerned about the structural nature of Colombia’s current account deficit, which even after a large real depreciation of the Peso, is expected to hover around 4% of GDP. Unlike Brazil, where I see it as one of the few bright spots, Colombia’s non-traditional exports have a high share of imported content and high transport costs, so the currency depreciation will help to revive exports by much less than I expected. Additionally, exports to its main trading partners (Ecuador and Venezuela) continue to fall. The bulk of the adjustment will need to come from lower imports as a result. With only about 50% of the current account deficit financed by foreign direct investment, the rest will likely need to be financed by sovereign external borrowing. The authorities are expecting that the forthcoming 4G infrastructure concessions will bridge a large share of the investment gap and the upcoming privatization of energy company ISAGEN will be closely watched, as the proceeds will help to leverage the infrastructure concessions. Consequently, there are downside risks to the fiscal outlook as well, which means debt levels will be increasing further. As a result, I expect the rating agencies to change the country’s outlook to negative, with a downgrade to BBB- should the tax reform disappoint and the infrastructure concessions be lower than expected.

]]>https://www.bondvigilantes.com/blog/2015/11/04/colombia-at-risk-of-a-rating-downgrade-to-bbb/feed/0Brazil: caught in a destructive trap between politics and economicshttps://www.bondvigilantes.com/blog/2015/10/27/brazil-caught-in-a-destructive-trap-between-politics-and-economics/
https://www.bondvigilantes.com/blog/2015/10/27/brazil-caught-in-a-destructive-trap-between-politics-and-economics/#respondTue, 27 Oct 2015 14:19:17 +0000https://www.bondvigilantes.com/?p=12746Part of the ABC of Latin American debt series

Brazil currently finds itself caught in a destructive trap between politics and economics.

On the political front, it is impossible to trade the daily noise and headline risk. The possible impeachment (45% probability as a guesstimate) of Rouseff would still be subject to various steps and legal challenges and could take a minimum of 6-9 months. Thr…

]]>Part of the ABC of Latin American debt series

Brazil currently finds itself caught in a destructive trap between politics and economics.

On the political front, it is impossible to trade the daily noise and headline risk. The possible impeachment (45% probability as a guesstimate) of Rouseff would still be subject to various steps and legal challenges and could take a minimum of 6-9 months. Three hundred and forty two votes are needed and the opposition only has about 280 votes at the moment. In the meantime, Congress would be fully distracted and the economy would continue to struggle until the uncertainties over who is in command are cleared. The ultimate goal of the opposition is to weaken the PT (Workers Party) as much as possible ahead of the 2016 midterm and 2018 presidential elections.

At the same time, local economists think that the economy is still three quarters away from bottoming out. Consumption is pressured by falling real wages and rising unemployment and investment is frozen until there is clarity on the political direction of the country. Net trade can make a small contribution, but not enough to turn things around as Brazil is a closed economy. In the meantime, the fiscal deterioration has been severe as revenues have an elasticity higher than one and more than 90% of expenditures are non-discretionary items that cannot be easily cut without congressional approval. Even a new administration, if weak, may not have enough support to de-index pensions and benefits from past inflation, which could allow Brazil to deflate itself out of a fiscal crisis. There is no chance of this happening under the current political environment. Other structural reforms, even if passed (e.g. public sector social security and pensions) would be a positive signal, but would only produce benefits in the long term. Additional tax increases to reduce the fiscal gap prompted an inconclusive but lively discussion of whether Brazil had already reached the optimal point on the Laffer curve –ie where further tax raises become counter-productive. The CPMF bank tax, which in theory can collect near 1% of GDP is unlikely to be passed (despite the carrot of sharing part of it with cash strapped local governments) as the opposition is conditioning this on spending cuts on politically sensitive areas (such as pensions), which the government is unwilling to tackle due to its low popularity and voter backlash. Brazil, like many other countries in the region, desperately needs growth to shore up its fiscal accounts.

Debt, as a result, will continue rising to 70-80% of GDP under the current path of primary deficits, negative growth and one of the world’s highest real rates.

Roll-overs, however, are not under threat at the moment, but the domestic debt could shorten further (in the 1980s, most of it was rolled overnight). A few state governments are also facing difficulties in servicing their debt, not to mention the Petrobras scandal (see Charles’ EM quasi-sovereign blog here).

The Central Bank is in an unviable position of facing near double digit inertial inflation (some of the proposed tax increases to reduce the fiscal deficit would push it even higher) in a recession and their reaction function appears to be tolerating higher near term inflation until there is greater clarity on the political and fiscal situation. I sense rates will be on hold for a while, despite inflation being way above the 4.5% target and 6.5% upper limit. The pressures to ease will intensify should inflation start declining.

On the positive side, Brazil’s current account will likely continue improving as the tourism deficit declines (see my earlier blog) and imports compress further. The Real has seen a large adjustment and is no longer overvalued, though I think it could weaken still further should Finance Minister Levy leave and there is further weakening in the fiscal accounts or pressure on the Central Bank to start easing prematurely. Despite ongoing currency interventions, Brazil’s gross reserves ($370 billion) remain above IMF recommended levels, under normal conditions. Capital flight has been manageable thus far. However, should that accelerate or should conditions worsen to the extent that the market starts demanding dollar spot as a hedge and not the counterparty risk of the Central Bank swaps ($110 billion notional), the reserve buffer can quickly dwindle.

Asset price levels as of late September (spreads, local rates and the currency) seemed to have priced a lot of the near term bad news. The pain trade was for positive news as the market was very defensively positioned. We have seen since then some short covering and a partial recovery of asset prices.

The consensus is that an impeachment of President Dilma would produce a market rally. If that happens, it could make sense to fade the rally as post-impeachment governability would still be difficult under a new (and possibly unelected) government, and many of the challenges will require deep structural reforms, particularly on the fiscal side. My take away is that things will get still worse before they get better.

]]>https://www.bondvigilantes.com/blog/2015/10/27/brazil-caught-in-a-destructive-trap-between-politics-and-economics/feed/0The ABC of Latin American debt: Argentina trip reporthttps://www.bondvigilantes.com/blog/2015/10/22/the-abc-of-latin-american-debt-argentina-trip-report/
https://www.bondvigilantes.com/blog/2015/10/22/the-abc-of-latin-american-debt-argentina-trip-report/#respondThu, 22 Oct 2015 13:15:12 +0000https://www.bondvigilantes.com/?p=12701I just spent two weeks traveling Latin America around the IMF meetings in Lima. The region is navigating through various shocks: lower commodity prices, deteriorating balance sheets, growth and fiscal deterioration, an urgent need for structural reforms and significant political challenges. There is plenty to write about, so in the next couple of days I will post a series of blogs focused on th…]]>I just spent two weeks traveling Latin America around the IMF meetings in Lima. The region is navigating through various shocks: lower commodity prices, deteriorating balance sheets, growth and fiscal deterioration, an urgent need for structural reforms and significant political challenges. There is plenty to write about, so in the next couple of days I will post a series of blogs focused on the ABC of Latin American debt: Argentina, Brazil and Colombia.

First stop, Argentina. Below is a summary of my trip, including what I believe are the key country issues and my impressions around them.

After a sleepless 13 hour red-eye flight from London, I decided to take it easy on my first day and make my touring day an educational one. The Argentine Congress and the External Debt Museum – both being related to market developments – seemed good visits for a warm up into my investor trip.

Officially back to the main purpose of my visit, the general elections happening this Sunday were one of the first topics to come up in conversations. There seems to be general consensus that the next administration will be better than the current one, which has helped Argentina’s hard currency debt to be the fourth best performing sovereign YTD. Although the elections are very close, there is the possibility that Daniel Scioli, the candidate who is closer to the existing government, wins in the first round. If he doesn’t, he will face a second round in November versus one of the two pro-market candidates (Mauricio Macri and Sergio Massa – Macri is currently ahead on the polls). I still think that Scioli will make it in the first round.

It is crystal clear what the country’s challenges are and what needs to be done. What is less clear is how gradual Scioli will be in addressing these challenges and how long his honeymoon with the markets will last. I expect the markets to allow him between 3 and 6 months before they start getting impatient and begin to test Scioli’s gradual and non-confrontational style.

Argentina faces a couple of challenges:

First, net international reserves have reached very low levels. Argentina’s access to the capital markets has been severely restricted due to the ongoing dispute with the debt holdouts. Until this is sorted, capital controls (“cepo”) remain in place, hindering foreign direct investment and maintaining elevated spreads as the country’s liquidity buffer vanishes. An agreement – at least with the main holdouts – is a necessary but not sufficient condition for stabilising the country’s challenging macroeconomic outlook. This would allow the country to gradually lift the capital controls, allowing for some foreign direct investment to resume and for the country to issue new external debt to recompose its reserves. An agreement will need to be rectified by the Argentine Congress, which despite no candidate achieving an absolute majority, is expected to pass. The devil is in the details.

Second, in addition to the holdout agreement, Argentina needs to move towards equilibrium in three areas:

a) The official exchange rate is clearly overvalued and will likely be devalued to some midpoint between the current official rate (9.50) and the parallel market (16.00), with a dual-exchange regime also being a possibility;

b) Real interest rates (Badlar) remain in negative territory and will need to rise for the devaluation to have some anchor;

c) The fiscal position (-6 to -7% of GDP) is unsustainable in the medium-term, unless growth rebounds strongly. At best however, we will see an adjustment of 1-2% through spending cuts and energy subsidy reduction in late Q1 2016.

In conclusion, I expect Argentine debt to continue to trade near current levels over the next few months, assuming a Scioli victory (and a rally should the opposition win, which is currently not priced in). I also see a binary scenario after Q2 2016: a sell-off to 12-13% yields should the issues listed above not be addressed adequately, or a rally to under 8% yields should they be.

]]>https://www.bondvigilantes.com/blog/2015/10/22/the-abc-of-latin-american-debt-argentina-trip-report/feed/0Will the thawing in US-Cuban relations bring havoc to the region’s bonds?https://www.bondvigilantes.com/blog/2015/08/04/will-thawing-us-cuban-relations-bring-havoc-regions-bonds/
https://www.bondvigilantes.com/blog/2015/08/04/will-thawing-us-cuban-relations-bring-havoc-regions-bonds/#respondTue, 04 Aug 2015 14:12:52 +0000https://www.bondvigilantes.com/?p=12096It is August and I should be enjoying a beach holiday, rather than being stuck in London under temperamental weather. To mitigate my despair, I decided to write some blogs on the topic of tourism. Given the ongoing normalisation of US-Cuba relations, I have been looking at the impact that this unprecedented shift in policy could have on the region. Although the embargo and travel restrictions r…]]>It is August and I should be enjoying a beach holiday, rather than being stuck in London under temperamental weather. To mitigate my despair, I decided to write some blogs on the topic of tourism. Given the ongoing normalisation of US-Cuba relations, I have been looking at the impact that this unprecedented shift in policy could have on the region. Although the embargo and travel restrictions remain in place and still need to be modified by the US Congress, an eventual lifting of sanctions would be a watershed event for the region. US Secretary of State John Kerry could take a few days off in Cuba after his visit this month and see first-hand the challenges and opportunities on the island.

The IMF published a solid assessment in 2008 on the implications for the Caribbean of opening US-Cuba tourism, which had a few notable findings. The liberalisation of US-Cuba tourism is expected to increase arrivals to the Caribbean by an estimated 10%. However, the impact on individual countries differs markedly depending on the composition of their existing tourist base. For example, countries that have the majority of tourists coming from the US are the ones that will stand to lose the most as these tourists head to Cuba instead. In the short-term, Cuban infrastructure could hit capacity constraints with the flood of new visitors. As the increase in number of US tourists displaces non-US tourists, the tourists could decide to holiday at other islands instead, resulting in a benefit from the Cuban effect, such as Dominican Republic.

The direct and indirect impact of tourism varies per country, as typically the smaller economies have less potential to diversify. For every Bermuda (insurance) or Cayman Islands (financial services), there are other countries that are struggling to diversify.

While financial investment in Cuba remains difficult given the lack of tradeable assets (to say that defaulted Cuban loans trade by appointment is an understatement), those seeking to benefit from the opening up of the Cuban economy and an increase in tourism could look to real estate related investments as the logical alternative. The increase in trade and tourism with the United States will not only benefit Cuba, but also its neighbours, which are mostly small open economies that depend on tourism to various degrees.

This shows that investors should not paint countries in the Caribbean with the same brush and this can create mispricing and opportunities in the marketplace for assets.

With that in mind, I see the credit trends and ratings skewed to the downside in countries like Aruba and The Bahamas as they continue to struggle to diversify their economies. As debt levels creep up there are also other likely losers from the Cuban opening. On the other hand, I am comfortable with credits such as Dominican Republic, which surprisingly may even benefit from the normalising of US-Cuban relations.

]]>https://www.bondvigilantes.com/blog/2015/08/04/will-thawing-us-cuban-relations-bring-havoc-regions-bonds/feed/0A message to Brazilian tourists: stop travelling abroad and help your countryhttps://www.bondvigilantes.com/blog/2015/07/29/message-brazilian-tourists-stop-travelling-abroad-help-country/
https://www.bondvigilantes.com/blog/2015/07/29/message-brazilian-tourists-stop-travelling-abroad-help-country/#respondWed, 29 Jul 2015 15:57:20 +0000https://www.bondvigilantes.com/?p=12081S&P placed Brazil’s foreign currency ratings (BBB-) on negative outlook yesterday, only one small step away from junk. S&P’s negative outlook implies that there is a probability higher than 33% that Brazil’s rating will be subject to a downward revision in the next 18 months. According to the statement, S&P “could lower the ratings if there were further deterioration in Brazil’s external and fi…]]>S&P placed Brazil’s foreign currency ratings (BBB-) on negative outlook yesterday, only one small step away from junk. S&P’s negative outlook implies that there is a probability higher than 33% that Brazil’s rating will be subject to a downward revision in the next 18 months. According to the statement, S&P “could lower the ratings if there were further deterioration in Brazil’s external and fiscal indicators resulting from what we might view as a backtracking by Brazil from its commitment to its stated policies and from the various policy corrections underway.”

In our view, a rating downgrade is inevitable. Brazil is suffering from challenges on a number of economic fronts, including a recession, high inflation, rising debt levels, a weak fiscal framework and negative terms of trade caused by weak demand for commodity exports. On the political side, the controversy caused by the massive Petrobras corruption scandal is resulting in political instability and investor aversion. It is difficult to see many positives in Brazil at this point in time apart from the fact that foreign exchange reserves remain at adequate levels when measured by various metrics. In addition, the Central Bank has been reducing the amount of currency intervention through swaps, a credit positive.

If we examine the current account trends, one factor that has deteriorated over the past decade has been the travel component. While the amount spent by foreign tourists in Brazil has remained relatively stable, the main deterioration is the result of Brazilians travelling abroad and spending their hard earned cash. This has been driven by the Real’s real appreciation.

It is interesting that the travel deficit did not begin to improve as the Real started to depreciate in 2011. One explanation can be that real wages were still rising until early 2014. With the economy now in recession, real wages have begun to fall and unemployment (a lagging indicator) has started rising as well.

Given these factors, we believe that the travel deficit will start shrinking over the next few quarters. If Brazilians stopped travelling overseas and chose instead to travel domestically, they would be accomplishing two things: reducing the current account deficit and stimulating the struggling domestic service economy. While that is a small step in context of this complex macroeconomic environment, every little bit counts.

]]>https://www.bondvigilantes.com/blog/2015/07/29/message-brazilian-tourists-stop-travelling-abroad-help-country/feed/0Five reasons EM debt is attractivehttps://www.bondvigilantes.com/blog/2015/05/05/five-reasons-em-debt-attractive/
https://www.bondvigilantes.com/blog/2015/05/05/five-reasons-em-debt-attractive/#respondTue, 05 May 2015 15:20:20 +0000https://www.bondvigilantes.com/?p=11770The consensus view on the outlook for Emerging Market (EM) bonds is bearish. Many point to risks posed by a Fed rate hike, falling commodity prices, possible Grexit and a slowing China as reasons to reduce investment allocations to the asset class. However, there is a solid investment case for EM debt at this point in time for those willing to have a closer look.

Firstly, geopolitical events ap…

]]>The consensus view on the outlook for Emerging Market (EM) bonds is bearish. Many point to risks posed by a Fed rate hike, falling commodity prices, possible Grexit and a slowing China as reasons to reduce investment allocations to the asset class. However, there is a solid investment case for EM debt at this point in time for those willing to have a closer look.

Firstly, geopolitical events appear to have stabilised in several regions across the globe. For example, there are encouraging early signs from the Ukrainian sovereign and corporate restructuring process, with successful negotiations between creditors and the government to extend the repayment terms of the state owned bank Ukreximbank. In Brazil, Petrobras has at last released its financial results, delayed by several months over its bribery scandal, which eliminates the risk of acceleration and technical default on its bonds. And in Tunisia and Kenya, where terrorist attacks have recently taken place, bonds have recovered to their previous levels after a brief period of underperformance. We would argue that these reduced tail risks are yet to be factored into investors risk assessment for these countries.

Secondly, inflation in some of the larger emerging market countries is now at a more benign phase. This will give the central banks some additional monetary policy flexibility, and they won’t be required to hike interest rates before the Fed starts doing so.

Thirdly, recent oil price developments also suggest more cheer in some emerging markets. Countries such as Venezuela, Ecuador and Iraq, heavily reliant on oil for export and fiscal earnings, would have faced a particularly negative macro environment, had oil prices continued declining into the USD40 range. With the oil price recovery, a Venezuelan default largely priced in for 2015 earlier in the year has now been pushed into 2016, removing another immediate tail-risk. Oil exporters such as Nigeria who have not yet allowed their currencies to depreciate have lost a considerable amount of foreign exchange reserves in defending their currency – but as oil prices have rebounded towards the USD50-60 range, earlier underperformance has been reversed. Additionally, the still generally low oil price is also a welcome tonic to the US consumer, helping emerging markets with close ties to the US economy such as Central America and the Caribbean, Mexico, and some Asian exporters.

Fourthly, EM bond yields are still attractive on a relative basis and investors still have the opportunity to acquire assets with yields over 7%. The relative value opportunity is especially the case given the very low level of developed market government bond yields. Additionally, EM issuers are exploiting the lower yields on offer in Europe and have started funding in EUR, as opposed to USD. Of course, some sovereign and corporate credits with large balance sheet mismatches are vulnerable in this environment, but there are also winners in the space, such as exporting corporates. Other winners include sovereigns that are already advanced in their current account rebalancing, such as India, Chile, Pakistan, Poland and Hungary.

Finally, flows into emerging market debt markets have slowed materially since 2013, thereby reducing the risk of Taper Tantrum-esque outflows should the Fed begin to hike rates. Arguably, some of the “hot-money” has already retreated from the asset class potentially reducing any future volatility.

I expect that EM debt will continue to look attractive in a world of ultra-low interest rates and loose monetary policy. The receding of geopolitical risks, low inflation, stabilisation in the oil price, strong relative value dynamics and reduced risk of outflows are solid tailwinds for the asset class in the remainder of 2015.

]]>https://www.bondvigilantes.com/blog/2015/05/05/five-reasons-em-debt-attractive/feed/0The falling US unemployment rate could benefit some emerging marketshttps://www.bondvigilantes.com/blog/2015/03/11/falling-us-unemployment-rate-benefit-emerging-markets/
https://www.bondvigilantes.com/blog/2015/03/11/falling-us-unemployment-rate-benefit-emerging-markets/#respondWed, 11 Mar 2015 12:04:49 +0000https://www.bondvigilantes.com/?p=11650The declining unemployment rate in the US has renewed the debate on the timing and pace of monetary tightening by the Fed. While wage pressures have been muted thus far, the risk is rising that further declines of unemployment will lower the rate below non-inflationary (NAIRU) levels and prompt the Fed to start hiking.

For emerging markets, one of the main transmission mechanisms is through wea…

]]>The declining unemployment rate in the US has renewed the debate on the timing and pace of monetary tightening by the Fed. While wage pressures have been muted thus far, the risk is rising that further declines of unemployment will lower the rate below non-inflationary (NAIRU) levels and prompt the Fed to start hiking.

For emerging markets, one of the main transmission mechanisms is through weaker EM currencies versus the US dollar. Additionally, many are concerned about higher funding costs as US Treasury yields rise further. These are significant concerns for EM investors. Despite the recent increase in euro bond issuance (a result of the lower yields on offer in Europe), most corporate external funding is still denominated in USD.

However, another transmission from the US recovery is through remittances. Remittances by US based workers to families in their home countries is highly correlated to economic activity in the US and it can disproportionally benefit a few countries. We can see from the chart above that the unemployment rate amongst the US’ Hispanic population (a proxy for their savings and eventual remittances) is improving at an even faster pace than the broader US workforce, which by itself is recovering at a solid pace. Part of this is because Hispanics are overrepresented in cyclical industries, such as construction.

Remittances have been found to contribute to lower growth volatility in the recipient country (as this recent IMF report pointed out). It also serves as a major social safety net, as the recipient countries generally have very low levels of income and savings and the availability of key services such as health and education is often scarce. Finally, remittances reduce a country’s current account deficit and external funding requirements, which is supportive should capital inflows into emerging markets decline.

The eventual Fed hikes will remain a key concern for many emerging markets. However there are countries that will benefit from the stronger US labour market, particularly those that stand to benefit from US employee remittances.

]]>https://www.bondvigilantes.com/blog/2015/03/11/falling-us-unemployment-rate-benefit-emerging-markets/feed/0Emerging Market debt: 2014 returns post-mortem and 2015 outlookhttps://www.bondvigilantes.com/blog/2015/01/07/emerging-market-debt-2014-returns-post-mortem-2015-outlook/
https://www.bondvigilantes.com/blog/2015/01/07/emerging-market-debt-2014-returns-post-mortem-2015-outlook/#respondWed, 07 Jan 2015 09:01:50 +0000https://www.bondvigilantes.com/?p=115002014 was quite an eventful year for Emerging market (EM) fixed income. After a period of strong performance which lasted all the way to September, markets corrected significantly in the latter part of the year as the escalation of the Russia crisis and the plunging oil prices triggered the most significant drawdown since the “taper tantrum” of June 2013. All in all, emerging markets still poste…]]>2014 was quite an eventful year for Emerging market (EM) fixed income. After a period of strong performance which lasted all the way to September, markets corrected significantly in the latter part of the year as the escalation of the Russia crisis and the plunging oil prices triggered the most significant drawdown since the “taper tantrum” of June 2013. All in all, emerging markets still posted a positive total return in 2014, despite the declines in local currency markets (see chart 1). Particularly important at this point of the cycle, asset allocation and avoiding a few deteriorating credits were key for performance.

Duration was one of the largest surprises in 2014

US Treasury yields rallied and this was one of the main tailwinds for returns – and also one of the biggest surprises of 2014. This made the asset allocation between hard currency and local currency a critical call – much more than what I had anticipated. While lower oil and commodity prices can help at the margin, they matter much less for US CPI than for other EM countries. The labour market and wages should remain more relevant for US monetary policy.

Spreads widened, particularly in oil related credits

Sovereign and corporate bond spreads ended the year about 40 basis points wider.

However, this masks two very distinct periods: tightening until the summer (as investors had been cautiously positioned in terms of risk and had to invest given the inflows into retail bond funds) and widening since then (as inflows have been reduced and risks have risen, particularly for the oil exporting countries). The latter countries have been the clear underperformers as the price of crude oil tumbled from $75 to $55 USD per barrel. With the markets testing OPEC’s response (or lack thereof), the oil credits will remain under pressure until there is more clarity on what the new floor for oil prices is.

Despite the recent correction, the asset class has been able to cope thus far with lower capital inflows than in prior years and this is part of a multi-year adjustment. The dispersion of returns between hard currency sovereigns and corporate bonds was lower than I had anticipated – partially reflecting the more benign US rate environment, with the tails impacting primarily weak credits such as Venezuela and Ukraine.

For 2015, I expect higher dispersion of returns, particularly in the credits that are under scrutiny by the markets. The jury is still out on whether these governments will deliver the required fiscal or structural adjustments necessary to stabilize debt levels (including countries that are being squeezed by lower commodity prices) and structural reforms required to increase potential growth. I remain very cautious on security selection in Brazil and South Africa and am avoiding select frontier markets (Ghana, Costa Rica, Serbia) and oil credits (Bahrain, Ecuador), where I believe investors are underestimating risks and where the adjustments are likely to disappoint.

Local currency debt: currency again leads to underperformance

The US yield rally helped to anchor local currency curves in various countries, but was not enough to offset the negative returns from EM currency depreciations against the US dollar. In all but one market (China), rates outperformed currency returns. EM currencies actually outperformed several developed currencies, particularly the EUR, but also NOK (oil theme) and AUD/CAD (commodity theme) and I view this year as being largely a USD rally as opposed to an EM sell-off (the Ruble being the most notable exception). In many instances, the currency depreciation has been relatively orderly and/or has not had a negative effect on sovereign or corporate balance sheets. Hence, it has not contributed to significant spread widening. A few countries, however, remain under severe pressure and have been amongst the underperformers. The magnitude of the Russian underperformance was staggering, which was one of the factors that caused its GBI-EM index weight to be reduced from 10% to 5%. EM local currency debt would have delivered only a small negative return (about -1%) had Russia been excluded. I remain cautious on currencies where the adjustment is still incomplete and where terms of trade have worsened, particularly in less flexible regimes such as Nigeria or former Soviet Union countries with strong economic linkages to Russia. After having a relatively low allocation to local currency debt in 2014, I am looking to selectively add exposure in 2015 to countries where the current account adjustment is advancing and/or valuations undershoot fundamentals. Indonesia and India were such examples in 2014 and managed to perform well despite a strong USD environment.

Idiosyncratic risks abounded, keep seatbelts on

I expected idiosyncratic risks in 2014 to become a more relevant source of returns, particularly political risks. I factor political risk by assessing whether it impacts the economy and whether the economy impacts asset prices, which is what we ultimately invest in.

In some cases, political risks had a positive impact (e.g. Indonesia and India). In other cases, while it impacted the economy, it had muted impact on asset prices (e.g. Thailand, which has had a long history of military involvement, with typically little impact on asset prices).

In other cases, political risks increased materially (e.g. Russia and Ukraine), which is having a significant impact on their economies and asset prices. I remain cautious on our exposure to these countries, as the ongoing instability risks spilling into a banking and regional crisis. One year into the conflict, I still do not see a speedy resolution in sight as the positions remain far apart and the west in no hurry to lift the economic sanctions, particularly the US. I wrote a blog on this last April which is available here.

Near the extremes, good returns in Argentina (despite being partially in default) and weak ones in Venezuela (not yet in default) highlighted the expectations for better economic policy in the former (post October 2015 elections) and little hopes of adjustment in the latter, made even more critical given lower oil prices.

For 2015, the election calendar will be much quieter than in 2014. The focus will turn into implementation of reforms, ongoing geopolitical issues and the policy response (or lack thereof) of countries that are being hurt by weakening terms of trade. This is particularly true for a few important countries, such as Brazil. While I view the recent cabinet appointments as a step in the right direction in terms of a better policy mix, we need to see steadfast and prompt improvements on the fiscal adjustment to anchor expectations and prevent a ratings downgrade.

In sum, I expect asset allocation between hard and local currency to remain a key driver particularly in the earlier part of 2015. Credit selection within the hard currency space will remain even more important than it was in 2014 as I expect return dispersion to increase and avoiding the tail-risk underperformers remains key.

]]>https://www.bondvigilantes.com/blog/2015/01/07/emerging-market-debt-2014-returns-post-mortem-2015-outlook/feed/0Emerging market debt: notes from my recent trip to the IMF Annual Meetingshttps://www.bondvigilantes.com/blog/2014/10/16/emerging-market-debt-notes-recent-trip-imf-annual-meetings/
https://www.bondvigilantes.com/blog/2014/10/16/emerging-market-debt-notes-recent-trip-imf-annual-meetings/#respondThu, 16 Oct 2014 10:01:04 +0000https://www.bondvigilantes.com/?p=11052Last week I attended the IMF’s Annual Meetings in Washington D.C, where I had a series of very interesting meetings with government officials and other world financial leaders. The underlying theme behind most of the discussions was that emerging market countries continue their adjustment into a new phase characterized by less abundant liquidity and lower commodity prices. This adjustment proce…]]>Last week I attended the IMF’s Annual Meetings in Washington D.C, where I had a series of very interesting meetings with government officials and other world financial leaders. The underlying theme behind most of the discussions was that emerging market countries continue their adjustment into a new phase characterized by less abundant liquidity and lower commodity prices. This adjustment process has thus far held a reasonably steady course, as the asset class has posted respectable returns year to date, part of that driven by lower US yields and part driven by the tightening of spreads and carry. Currencies, which is one of the main channels of adjustment to this new environment have been depreciating, which is something I had highlighted earlier in the year.

Looking into 2015, concerns are shifting from US rates into more specific EM factors. A slowdown of growth in China and other countries was the main concern voiced through the meetings. This reflects an uneven global recovery, where the US is unable to fully offset the growth drag coming from the Eurozone and Japan. Additionally, geopolitical events and country specific structural issues have also contributed to the slowdown.

In Ukraine, expectations of a restructuring through a voluntary maturity extension seems widely expected, despite the supportive rhetoric coming from IMF officials, suggesting that additional funding may be provided given the higher financing required as a result of the country’s worse than expected conflict. Despite the supportive rhetoric, I remain cautious on the credit at these levels, with the view that there can be contagion arising from defaults of state owned banks in the years ahead as they will have access to Hryvnia liquidity from the Central Bank, but no preferential access to USD given Ukraine’s weak international reserve position.

Venezuela’s default expectations seem lower than implied by market prices. I believe the disconnect reflects the uncertain recovery value on the credit compared to prior emerging market restructurings. The amount and seniority of additional claims, such as dollar claims by importers, airlines, compensations for past nationalization of assets by the state and state arrears make the recovery exercise a difficult one.

Argentina will face a difficult year ahead given its stagflation and declining reserves, though it has a slight advantage versus the two other distressed credits in the sense that a new administration is likely to pursue more orthodox economic policies than the current administration. Still, the country’s legal dispute with the holdouts will extend well into next year and there is also the risk that a bond acceleration on the Defaulted Par bonds makes this situation even more complex.

Brazil’s upcoming second round elections on October 26 will be critical. Foreigners are more sceptical that the pro-market Aecio Neves could win. I see the elections a little less binary than the markets. Aecio’s ability to push reforms through Congress can disappoint, given Brazil’s fragmented party structure. At these levels, however, I see more upside in asset prices and particularly local rates should he win, than I see downside should Dilma be re-elected.

As for Russia, its ability to maintain its investment grade rating largely depends on how long with the conflict with Ukraine will last. Relations with the West, particularly with the US have hit bottom and are at the lowest point since the Cold War. US authorities remain quite relaxed in terms of maintaining their sanctions for a very long time if needed. I remain cautious on the credit, but believe that spreads already reflect the deterioration in capital flows, international reserves and the recent decline in oil prices. Credit risk between the sovereign and select state champions such as Gazprom or the larger state owned banks should continue.

In terms of overall asset allocation, there is little consensus on what will outperform next year, whether it is external debt, local debt or corporates. More of a consensus, however, is the fact that return expectations are conservative, with low single digits expected. Reflecting this, inflows into the asset class are expected to remain positive, but materially below levels seen before 2013.

In local currency bonds, I believe the recent rally in US rates and fall in commodity prices warrants adding duration in some countries. Various EM Central Banks are willing to allow for additional currency weakening without the need to tighten monetary policy. They believe that any pressures on inflation will be perceived by economic agents to be temporary, particularly in countries such as Chile where an output gap exists, or in countries such as Colombia that have been tightening policy.

I expect returns to be more muted in hard currency next year and the gap between hard and local currency bond returns should not be as wide as this year’s. In addition, country selection remains key and we have already been witnessing this differentiation over the last few years.

]]>https://www.bondvigilantes.com/blog/2014/10/16/emerging-market-debt-notes-recent-trip-imf-annual-meetings/feed/0Playing Russian roulettehttps://www.bondvigilantes.com/blog/2014/04/30/playing-russian-roulette/
https://www.bondvigilantes.com/blog/2014/04/30/playing-russian-roulette/#respondWed, 30 Apr 2014 11:23:01 +0000https://www.bondvigilantes.com/?p=10534The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability bu…]]>The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability but high impact game.

I just returned from a trip to Moscow. You would not know there is the possibility of a war going on next door by walking around the city, if you didn’t turn to the news. Its picture perfect spring blue skies were in stark contrast to the dark clouds looming over the economy.

The transmission mechanism of the political impact into the economy is fairly predictable:

Pressure for higher rates as the ruble weakens (the CBR has already hiked rates by 200 bps, including the unexpected 50bps hike last week, but more will be needed if demand for hard currency remains at the Q1 2014 level and pressure on the currency increases further);

Downside pressure on growth as investment declines and through the impact of sanctions or expectation of additional sanctions (through higher cost of capital);

Downward pressures on international reserves as the capital account deteriorates and CBR smoothens the currency move;

Decline of the oil reserve fund should it be used for counter-cyclical fiscal purposes or refinancing of maturing debt (the $90 billion fund could theoretically cover one year of amortizations, but in that case, capital flight and dollarization would escalate further as the risk perception deteriorates).

All these elements are credit negative and it is not a surprise that S&P downgraded Russia’s rating to BBB-, while keeping it on a negative outlook. What is less predictable, however, is the magnitude of the deterioration of each of these elements, which will be determined by political events and the extent of economic sanctions.

My impression was that the locals’ perception of the geopolitical risks was not materially different from the foreigners’ perception shown above – i.e. that a major escalation in the confrontation remains a tail risk. The truth is, there is a high degree of subjectivity in these numbers and an over-reaction from either side (Russia, Ukraine, the West) can escalate this fluid situation fairly quickly. The locals are taking precautionary measures, including channelling savings into hard currency (either onshore or offshore), some pre-emptive stocking of non-perishable consumer goods, considering alternative solutions should financial sanctions escalate – including creating an alternative payment system and evaluating redirecting trade into other currencies, to the extent it can. Locals believe that capital flight peaked in Q1, assuming that the geopolitical situation stabilizes. Additional escalations could occur around 1st and 9th of May (Victory Day), as well as around the Ukrainian elections on 25th of May.

The table below assigns various CDS spread levels for each of the scenarios, with the probabilities given per the earlier survey. The weighted probability average is still wider than current levels, though we have corrected by a fair amount last week. I used CDS only as it is the best proxy hedge for the quasi-sovereign and corporate risk. Also, the ruble would be heavily controlled by the CBR should risk premia increase further, and may not work as an optimal hedge for a while, while liquidity on local bonds and swaps would suffer should the sanctions directly target key Russian banks.

The risk-reward trade-off appears skewed to the downside in the near term.

]]>https://www.bondvigilantes.com/blog/2014/04/30/playing-russian-roulette/feed/0World Cup currency trading strategies: emerging vs. developed marketshttps://www.bondvigilantes.com/blog/2014/04/14/world-cup-currency-trading-strategies-emerging-vs-developed-markets/
https://www.bondvigilantes.com/blog/2014/04/14/world-cup-currency-trading-strategies-emerging-vs-developed-markets/#respondMon, 14 Apr 2014 14:44:29 +0000https://www.bondvigilantes.com/?p=10494With just under two months to go to the opening match and tensions already mounting within our team (we have 8 different participating countries covered – Australia, Brazil, England, France, Germany, Italy, Spain and USA), we thought it was time for a World Cup themed blog. Our prior predictor of the 2010 World Cup winner proved to be perfectly off the mark. Based on expected growth rates in 20…]]>With just under two months to go to the opening match and tensions already mounting within our team (we have 8 different participating countries covered – Australia, Brazil, England, France, Germany, Italy, Spain and USA), we thought it was time for a World Cup themed blog. Our prior predictor of the 2010 World Cup winner proved to be perfectly off the mark. Based on expected growth rates in 2010, we predicted that Ghana would win and Spain would come last – and we know what happened subsequently. However, in defence of the IMF, Ghana were the surprise package of 2010, only failing to reach the semis thanks to a Luis Suarez handball.

However, despite the tradition of ‘lies, damned lies, and statistics’, I still believe in analysing data and making predictions. Was it coincidence that the team that was not part of our predictions (North Korea), given the lack of available economic data, ranked last? Would Argentina have made it to the quarter-finals had it not been altering its inflation statistics?

Historically, the World Cup has been won 9 times by an emerging country and 10 times by a developed country. Will an emerging country win and tie the score this year?
We present two currency trading strategies associated with the World Cup:

Arbitrage: in currencies with full convertibility or minimal transaction costs, arbitrage opportunities are very limited. However, currencies that are subject to restrictions on capital flows, taxation or regulatory requirements often offer arbitrage opportunities in excess of the costs associated with these factors. For example, for the World Cup in Brazil, ticket prices for non-residents are determined in USD and in BRL for Brazilian residents. Ticket prices were set by FIFA in May 2013 (1980 Brazilian Reals or 990 US Dollars for category 1 tickets), based on the prevailing US Dollar / Brazilian Real exchange rate of 2.00. As ticket prices remain unchanged in USD and BRL and given the depreciation of the Real since then, ticket prices in BRL are now 14% cheaper than tickets purchased in USD.

Currency carry trades: a popular strategy which is relatively easy to implement and which has proven profitable1. We test the strategy by going long a basket of emerging market currencies of the qualifying countries (which are normally higher yielding due to higher inflation, economic risks, etc.) funded by a basket of developed market currencies of the qualifying countries (which are normally lower yielding, which has been exacerbated by quantitative easing). Out of the countries that qualified for the recent World Cups, we arbitrarily classify them as 18 emerging and 14 developed. However, if we measure them by currency, the numbers change slightly. A few emerging countries have a developed market currency as legal tender (for example, Ecuador adopted the US Dollar as its legal tender in 2000), so it makes sense to count them as developed countries. We keep Ivory Coast under the emerging basket, as the West CFA Franc, while pegged to the Euro, is not the same as having Euro as its legal tender.

We test our World Cup carry trade performance during the last 2 World Cups between January 1 (a clean start date once the 32 qualifying teams became known) and the start dates for each tournament.

The EM vs DM FX carry trade posted a small profit in 2006 (+0.4%) and was a clear winner in 2010 (+2.4%)2 . On the football field, however, emerging market lost to developed market in both instances (Italy and Spain won). Ahead of the upcoming cup, the carry total return points to a loss on the EM carry trade so far (-2.8% to the 11th of April). On this basis, I predict that an EM team will win the cup in Brazil.

1For an empirical discussion of emerging market carry trades, see http://www.nber.org/papers/w12916.pdf?new_window=1.2For simplicity reasons, we have omitted bid-offer transaction costs from the calculations. Given that some of the smaller EM currencies are less liquid and have higher costs (in this case, one buy and subsequent sell), the results slightly overstate the returns of the EM long side. On the short side, we only included the Euro once, to maintain a “diversified” basket of developed currencies.

]]>https://www.bondvigilantes.com/blog/2014/04/14/world-cup-currency-trading-strategies-emerging-vs-developed-markets/feed/0The emerging markets rebalancing acthttps://www.bondvigilantes.com/blog/2014/04/02/emerging-markets-rebalancing-act/
https://www.bondvigilantes.com/blog/2014/04/02/emerging-markets-rebalancing-act/#respondWed, 02 Apr 2014 07:45:06 +0000https://www.bondvigilantes.com/?p=10460Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with…]]>Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits. Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption.

In our latest issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.

]]>https://www.bondvigilantes.com/blog/2014/04/02/emerging-markets-rebalancing-act/feed/0Emerging market debt: 2013 returns post-mortem and themes for 2014https://www.bondvigilantes.com/blog/2014/01/07/emerging-market-debt-2013-returns-post-mortem-and-themes-for-2014/
https://www.bondvigilantes.com/blog/2014/01/07/emerging-market-debt-2013-returns-post-mortem-and-themes-for-2014/#respondTue, 07 Jan 2014 10:19:44 +0000https://www.bondvigilantes.com/?p=10207Emerging market (EM) fixed income posted its third negative performance year since 1998, driven by rising US Treasury yields, fears of tapering, and concerns around declining capital inflows from developed markets into emerging markets. A number of EM countries were also hindered by country-specific drivers such as slowing growth, decreasing productivity, twin deficits, and exposure to a slowi…]]>Emerging market (EM) fixed income posted its third negative performance year since 1998, driven by rising US Treasury yields, fears of tapering, and concerns around declining capital inflows from developed markets into emerging markets. A number of EM countries were also hindered by country-specific drivers such as slowing growth, decreasing productivity, twin deficits, and exposure to a slowing Chinese economy. EM fixed income still saw inflows for 2013 of $9.7bn, although this was way behind the $97.5bn inflows of 2012, and the asset class has seen outflows of around $40bn since May (source EPFR, JP Morgan).

Within the asset class, EM corporate bonds outperformed EM sovereign debt, with the former returning -0.6% and the latter -5.3% in 2013. This sub-asset class benefited from its shorter duration and tangential spill-over (or higher correlations?) from the stronger performance in global investment grade and high yield credit. EM corporate bond spreads, measured by the JP Morgan Corporate EMBI index, are now flat to hard currency sovereign debt which translates into a narrowing of 66 bps since the beginning of 2013.

Therefore, the asset allocation between EM sovereigns in both hard and local currency and EM corporates was one of the key calls for performance in 2013. Sovereign bonds underperformed over the year, with hard currency debt delivering a negative return of -5.3%, also due to the fact that it has the longest duration of all three sub-asset classes. However, local currency debt faced a particularly challenging year, delivering a negative total return of -9.0% which can be mostly attributed to the foreign exchange component of the bond, while the carry, i.e. the additional return due to higher local interest rates, compensated for the back-up in yields.

It is worth though having a closer look at the underlying dynamics as it helps to further understand the drivers of performance in 2013 and how 2014 will be different.

1) Most of the negative return of EM hard currency sovereign debt was driven by rising US Treasury yieldsand less by the perceived deterioration in EM credit profiles and widening of EM spreads.
The negative impact of widening credit spreads was modest, contributing -0.5% to the total return of hard currency sovereign debt as the chart above shows. To put this into perspective, spreads widened by 50 bps in 2013, while 10 year US Treasury yields backed up by 116 bps. Hence, duration management was key in 2013. With tapering priced in and the US Treasury forward curve pricing 10 year US Treasury yields at around 3.5% by year end, an additional backup in US rates should be less pronounced in 2014 than it was in 2013. The risk to this outlook is for stronger than expected data and/or worsening of inflation expectations, which is not priced in at the moment. That is, a bear flattening of the US curve through pushing forward the anticipated hikes in the Fed Funds rate (currently priced for 2015 and beyond) is a risk to be monitored carefully.

2) The performance of hard currency sovereign debt was not necessarily better for countries that are perceived to be more resilient, i.e. have lower debt levels, stronger liquidity, fiscal and current account position, sustainable growth as well as reform momentum, than for those that are perceived to be more vulnerable.Let’s take Mexico, one of the stronger emerging market economies, and South Africa, an increasingly vulnerable emerging market country, as an example. Mexican government debt denominated in hard currency returned -7.1%, while the total return for South Africa’s government bonds stood at -6.9%. One explanation is that the channel of adjustment in the current account deficit countries is weaker currencies and/or higher interest rates which may not be such a negative factor for sovereign debt spreads. Countries that allow for a free floating currency minimise net international reserve losses, which is supportive for the performance of hard versus local currency debt. In fact, the major performance difference between these two countries was precisely on their local currency debt (see below), where Mexico justifiably outperformed South Africa.

3) Another characteristic of 2013 was the outperformance of those bonds associated with higher credit risk, such as high yielders and frontier markets.
The JPMorgan Next Generation Markets Index (NEXGEM), an index for frontier market sovereign bonds rated BB+ and lower, returned +5.1% in 2013. This may seem counterintuitive given the recent change of sentiment towards EM assets, but it is refreshing that the market differentiated between the various emerging market issuers and rewarded the stable or improving credit profile of the weaker issuers with positive returns and re-priced deteriorating stories into negative returns. Argentina, for example, returned +19.1% on the delayed court decision regarding the holdouts, as well as on expectations for better economic policies with a new government in 2015. Venezuela, on the other hand, returned -12.3% on continued growing macroeconomic and political imbalances. In addition, Eichenberg and Gupta find that countries which allowed for large increases in their current account deficits and for a sharp appreciation of their currencies, saw indeed a stronger valuation correction, but also suggest that bigger and more liquid emerging markets experienced, generally speaking, more pressure on currency and debt valuations. Identifying the critical bottom-up, idiosyncratic factors was hence key in 2013 and will remain so in 2014, given the large rally we have seen in most of these frontier market bonds and, therefore, less favourable valuations.

4) Local currency debt was the key underperformer.
The bulk of the losses in emerging market debt issued in local currency was due to currency depreciation, which was one of the key transmission mechanisms in 2013 to potential lower capital flows into emerging markets. As such, various currencies will continue their move to fair value or undervaluation, if warranted, through 2014 as well. An eventual narrowing of current account deficits in countries that require an adjustment but do not face major structural rigidities, such as Brazil, India or Indonesia, should slow the depreciation pressure and, thus, performance in 2014 should not be as negative. That is, the balance of risks and market focus should then be centred on the capital account.

5) Positive carry and a lower duration have provided an anchor of support for local currency debt returns.Local currency yields rose by 135 bps in 2013 to 6.85%, driven by currency weakness (South Africa), monetary policy tightening (Brazil, Indonesia), fiscal deterioration and inflation risk (Brazil), political and external account concerns (Turkey), as well as a higher floor from US yields. The carry, however, and a lower average duration on local currency debt, for which a comparable index has a duration of 4.6 years, allowed for the total return in local currency terms to be flat in 2013 and provide a better cushion for 2014.

6) Political risks were pretty muted in 2013 (with a few exceptions), but are likely to increase significantly in 2014.Though countries like Turkey and Ukraine as well as the Middle East faced serious political crises, politics did not play a major role for the asset class in 2013. However, 2014 will be a year in which the return impact from idiosyncratic political events in emerging markets could increase substantially. Twelve of the major emerging market countries will have presidential and/or parliamentary elections, including all the ‘fragile 5’ countries, i.e. Brazil, India, Indonesia, South Africa and Turkey – and we will comment in more detail on this in a forthcoming blog closer to the election dates. The prospect of these elections could potentially reduce the net capital flows into these economies on a temporary basis, such as through local capital flight, delayed foreign direct investment (FDI) and/or portfolio flows as well as increased demand for foreign exchange (FX) or credit default swap (CDS) hedging etc., pending the outcome of the elections and subsequent prospects for future economic policy and support for reforms.

In summary, the asset allocation between EM sovereigns in both hard and local currency and EM corporates should be less important in 2014 than it was in 2013, given that the forward yield curve implied levels for US interest rates is already pricing 10 year yields in the mid 3% range. Furthermore, the relative value opportunity between these three asset classes has decreased after the underperformance of sovereign debt in 2013 and the narrowing of EM corporate bond spreads on the back of the rally in global credit in both the investment grade and high yield space. In addition, valuations for local currency debt look better, also on the basis of the exchange rate adjustments seen in 2013 and higher yields. In other words, we expect the difference on performance, on aggregate, to be more muted at the top down level.

On the other hand, idiosyncratic EM events, including political events, will become more relevant, which makes bottom up security selection and timing, i.e. the repositioning through bouts of volatility, even more critical in 2014 . Global macro factors and drivers of global risk appetite, such as economic growth and inflation, China’s rebalancing efforts, commodity prices as well as developments in the Eurozone, will remain equally important.